Ch. 15: Capital Structure: Limits to the Use of Debt
If a firm that has an annual debt obligation of $40 and generates cash flow of $30, how much will shareholders receive?
0
Which of the following will increase the value of stocks and bonds?
A reduction in the claims of lawyers AND A reduction in government taxes
Who are the main claimants of a firm's cash flows?
Bondholders AND Government AND Stockholders
Marketable claims include the claims of the ___.
Bondholders AND Shareholders
Who pays to gain the privilege of receiving cash flows in the future?
Bondholders AND Shareholders
What are some ways in which a bankruptcy filing might hinder a firm's normal business operation?
Customers may not buy, fearing future service problems AND Banks may place restrictions on the firm's financial activities AND Suppliers may not supply inventory, fearing nonpayment.
Firm value initially increases when the proportion of debt in the capital structure increases due to the ___.
Debt Tax Shield
Which costs of financial distress are easier to measure?
Direct costs
Why do firms prefer debt over equity as a source of external financing?
Equity has more risk than debt AND Debt is less likely to be mispriced
When is a rational firm likely to increase the level of debt so as to capture the tax shield benefit of debt?
If profits are expected to be high.
Which two of the following are broad types of costs of financial distress?
Indirect costs AND Direct costs
What is the impact on the present value of distress costs as more debt is added?
It increases
What are the advantages of using internal financing?
It prevents the adverse market reaction that tends to accompany a stock issue AND It may be cheaper than debt or equity issues
What are the benefits of having fewer lenders during bankruptcy?
It reduces the conflicts among lenders AND It makes it easier for the firm to negotiate with lenders.
Nonmarketable claims include claims of the ___.
Lawyers AND Government
What is generally the most important component of direct costs of financial distress?
Legal costs
The pecking-order theory predicts that profitable firms will use ___.
Less leverage
Protective covenants benefit shareholders by ___.
Lowering interest rates on bonds AND Increasing firm value
Why is MM's assertion about the positive relationship between firm value and leverage not observed in the real world?
MM did not consider bankruptcy costs
Which one of the following is true about marketable claims?
Marketable claims can be bought and sold in financial markets.
What type of covenants may restrict shareholders from pursuing high-risk investments during financial distress?
Minimum net worth restrictions AND Minimum interest coverage restrictions
Agency costs ___ the value of a levered firm.
Reduce
Highly profitable firms are likely to have higher debt ratios because they can deduct interest for ___ purposes.
Tax
One of the important reasons why firms choose to raise capital by issuing debt is because of the ___ benefits of debt.
Tax
Which theory of capital structure leads to a target debt ratio?
The static trade-off theory of capital structure
What is the effect of possible bankruptcy costs on the value of a firm?
They reduce the value of the firm.
Which of the following factors affect the establishment of a target debt-equity ratio?
Uncertainty of operating income AND Type of assets, tangible or intangible AND Taxes
Bondholders want to restrict the sale of corporate assets to avoid ___.
Underinvestment by the firm AND The transfer of corporate assets to shareholders
What are some possible consequences of raising debt to fool the market about a firm's value?
When the market discovers the truth, share prices will drop AND The probability and expected costs of financial distress will increase if debt rises above the optimal level
Management strives to ___ the value of marketed claims.
maximize
During bankruptcy, the ownership of the firm's assets is transferred from stockholders to ___.
Bondholders
The payment to lawyers become relevant in the context of capital structure decisions in the event of ___.
Financial distress
Marketed claims can be bought and sold in ___.
Financial markets
The weighted average cost of capital rises at higher levels of debt owing to:
Financial distress costs
Why would bondholders want to put restrictions on additional borrowing by the firm?
An increase in borrowing will dilute the claims of existing bondholders.
Which of the following are examples of signaling by a firm?
An increase in dividends AND An increase in the target debt ratio
___ exists when a firm's manager knows more about the firm's prospects than the typical investor does.
Asymmetric information
When is the present value of distress costs likely to exceed the present value of the tax shield from debt?
At high levels of debt
From a tax shield perspective, why would a firm with low profits not borrow much?
Because the firm needs only a small interest deduction to offset pretax profits.
In bankruptcy cases, the claims of lawyers are ___ the claims of senior bondholders.
Given priority over
