Chapter 16 Financial Leverage and Capital Structure Policy
According to the Tax Cuts and Jobs Act of 2017, after 2021, the net interest deduction drops to what percent of EBIT?
30
In 2019, the net interest deduction is limited to what percent of EBITDA?
30
If a firm has annual debt obligations of $50 to the bondholders and generates cash flow of $40, how much will the bondholders will receive?
40
Holding equity in an unlevered firm has no risk?
False
Stockholders and bondholders _____.
are not the only claimants to the cash flows of the firm
Financial Distress Costs
the direct and indirect costs associated with going bankrupt or experiencing financial distress
Absolute Priority Rule (APR)
the rule establishing priority of claims in liquidation
Interest Tax Shield
the tax saving attained by a firm from interest expense
Homemade Leverage
the use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed
Crane Co. has annual obligations of $30 toward interest and principal and is forecasting a cash flow of either $25 (Scenario I) or $50 (Scenario 2) in the coming year. What will the payment to shareholders be in the two scenarios?
$0 in Scenario 1 and $20 in Scenario 2
Which of the following are consequences of nonpayment of debt obligations?
A firm may be forced to file for bankruptcy. The firm will encounter some form of financial distress
Which of the following is not a possible cause of financial distress?
Accounting regression
Which of the following industries tend to have a high leverage?
Airlines Cable television
Rank each of the following in order of priority of payment starting with the highest priority item to lowest priority item.
Bankruptcy administrative expenses Wages, salaries, and commissions Consumer claims Payment to common shareholders
Which of the following assumptions is necessary for MM Proposition I to hold?
Individuals can borrow on their own at an interest rate equal to that of the firm.
Bankruptcy is very valuable due to which of the following?
It can be used strategically to improve a firm's competitive position. Payments to creditors cease pending the outcome of the bankruptcy process.
Which of the following is not a reason that bankruptcy may be valuable to a company?
It generally instills greater confidence among a firm's main customers.
What is the impact on the present value of distress costs as more debt is added?
It increases
What is the most important benefit of debt?
It provides a tax benefit.
Financial distress can arise in the form of possible:
Legal bankruptcy Business failure
What is generally the most important component of direct costs?
Legal costs
Which of the following are nonmarketed claims to the firms cash flows?
Legal fees Taxes
What are some examples of indirect financial distress costs?
Lost reputation Lost sales
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.
How does the level of debt affect the weighted average cost of capital (WACC)?
The WACC initially falls and then rises as debt increases.
A corporation gains no value from an interest tax shield if which of the following are true?
The corporation has no debt. Corporate tax rates are zero. The corporation is an all-equity firm.
Which of the following are generally true about the cost of equity and the cost of debt?
The cost of debt is generally lower than the cost of equity. The cost of debt increases with leverage. The cost of equity may increase with leverage.
Who is likely to have the most information about a firm's future prospects?
The firm's manager
Which of the following is not a way in which a firm's normal business operations is hampered by bankruptcy?
The government may increase taxes on future sales.
What is the upper limit on payments to bondholders by the corporation regardless of the level of profits?
The obligation due in terms of interest and principal.
Which of the following is likely to be true when a bankruptcy ruling is issued?
The ownership of assets is transferred from the shareholders to the bondholders.
Which capital structure theory suggests that profitable firms will use less debt?
The pecking order theory
Which of the following will apply when a firm's debt levels are extremely high?
The possibility of financial distress will become a chronic problem. The benefits of debt financing may be more than offset by the costs of financial distress.
An investor who invests in the stock of a levered firm rather than in an all-equity firm will require:
a higher expected return.
If the degree of leverage increases, the cost of debt will ______.
increase
Place the steps needed to calculate the value of a levered firm with perpetual cash flows in order starting with the first step.
Calculate EBIT Multiply EBIT by 1 minus the corporate tax rate. Divide by the cost of equity for an all equity firm Add the present value of the debt tax shield.
Based on the static theory, what should the managers attempt to maximize and minimize while developing capital structure policy? Multiple choice question.
Maximize the tax shield benefit of debt and minimize financial distress costs
What is the effect of possible bankruptcy costs on the value of a firm?
They reduce the value of the firm.
In the extended pie model, bankruptcy costs are a claim on cash flows of the firm.
True
During bankruptcy, the ownership of the firm's assets is transferred from stockholders to ___.
bondholders
The equity risk that comes from the nature of a firm's operating activities is known as _____ risk.
business
The two broad types of costs of financial distress are ___ costs.
direct and indirect
According to M&M Proposition I, a firm's capital structure choices _____.
do not affect the value of the firm
According to critics of Modigliani and Miller (M&M), M&M capital structure theory ____.
does not work when real-world issues are factored in
Financial leverage affects the performance of a firm because the range of possible values for ___.
earnings per share is wider
An unlevered firm ____.
has an all-equity capital structure
Financial slack helps firms avoid ___.
having to rely on external financing
The cost of equity is generally ______ ______ the cost of debt.
higher than
In the presence of corporate taxes, the tax shield effect of debt will ____ the value of the firm.
increase
Customers refusing to buy GM cars when it filed for Chapter 11 for fear of not being able to service the cars in the future is an example of ______ costs of financial distress.
indirect
According to critics of Modigliani and Miller (M&M), M&M capital structure theory is _____.
irrelevant
Under the pecking order theory, profitable firms will tend to have ______ levels of debt.
lower
Volatility or ______ increases for equity holders when leverage increases.
risk
Financial ___ is the term used to describe when a firm stockpiles internally generated cash in order to avoid selling new equity.
slack
The ___ theory is the dominant theory of capital structure.
static
A beneficial rule to follow is to set the firm's capital structure so that ___.
the firm's value is maximized
Which of the following industries tend to have low leverage?
Drugs
According to the pecking order theory, what is the preferred source for firms seeking to raise capital?
Retained earnings
Which of the following statements are true regarding the effect of financial leverage and the firm's operating earnings?
Below the indifference or break-even point in EBIT, an unlevered capital structure is best. Financial leverage increases the slope of the EPS line. The rate of return on assets is unaffected by leverage.
Based on the static theory, what should the managers attempt to maximize and minimize while developing capital structure policy?
Maximize the tax shield benefit of debt and minimize financial distress costs
How do predictions for leverage by profitable firms differ under the pecking order theory and the static theory?
Pecking order theory predicts that profitable firms will use less leverage.
Which theory of capital structure leads to a target debt ratio?
The static trade-off theory of capital structure
MM Proposition II shows that ___.
the cost of equity rises with leverage
MM's assertion of a positive relationship between firm value and leverage is widely observed in the business world.
False
The costs of financial distress depend mostly on how easily the ownership of the firm's ________ can be transferred.
assets
The manager of a firm should change the capital structure if and only if ___.
it increases the value of the firm
Unlevered Cost of Capital
the cost of capital for a firm that has no debt
The risk of too much _______ is bankruptcy.
leverage
Under pecking order theory firms can choose between debt or equity for external financing, which will they prefer?
Debt
In determining the optimal capital structure, managers should keep in mind that lower effective tax rates lead to greater incentives to borrowing.
False
It is easy to measure indirect costs of financial distress.
False
______ is the term that describes the capital structure when debt is used to finance assets.
Financial leverage
What is the preferred source of financing for firms according to the pecking-order theory?
Retained Earnings Debt Common Stock
What are the two components of the static theory?
The tax benefits of debt and the costs of financial distress
What is the expression for the value of a levered firm in the presence of corporate taxes?
Value of Levered Firm = Value of Unlevered Firm + Tax Benefit of Debt
With ____, an investor is able to replicate a corporation's capital structure by borrowing funds and using those funds along with her own money to buy the company's stock.
homemade leverage
Direct bankruptcy costs are costs that are directly associated with bankruptcy such as ___ and administrative expenses.
legal
M&M Proposition I does not work with corporate taxes because ___.
levered firms pay lower taxes than unlevered firms
The value of a levered firm will be greater than the value of an identical unlevered firm because the levered firm's taxes will be:
lower.
A company should select the capital structure that _____.
maximizes the company's value
The benefits of debt financing _____ the costs of financial distress.
may be more than offset by
The value of the firm is maximized when the weighted average cost of capital (WACC) ___.
minimized
The value of the firm is maximized when the weighted average cost of capital (WACC) is _____.
minimized
The possibility of bankruptcy costs has a(n) ______ effect on the value of the firm.
negative
The absolute priority rule establishes priority _____.
of claims in liquidation
If a firm issues new equity, investors will infer that the firm's outstanding stock must be ___.
overvalued
The expected return on equity is _____ to leverage.
positively related
The value of a firm is equal to the value of its _____.
debt plus equity
Financial distress costs will ________ the value of the firm.
reduce
The ______ theory has dominated thinking about capital structure for a long time.
static
In the absence of taxes, the value of a firm is the same with debt financing as it is with equity financing because ___.
the asset to be financed is the same MM demonstrated that debt financing is neither better nor worse than equity financing in the absence of taxes
It is often in everyone's best interest to devise a "workout" strategy that avoids bankruptcy because _____.
the bankruptcy process can be long and expensive
Indirect Bankruptcy Costs
the costs of avoiding a bankruptcy filing incurred by a financially distressed firm
Direct Bankruptcy Costs
the costs that are directly associated with bankruptcy, such as legal and administrative expenses
Financial Risk
the equity risk that comes from the financial policy (the capital structure) of the firm
Business Risk
the equity risk that comes from the nature of the firm's operating activities
A firm's capital structure refers to ___.
the firm's mix of debt and equity
Under the MM propositions with no taxes, managers cannot change the value of the firm by repackaging its securities because __.
the overall cost of capital cannot be reduced as debt is added, the equity becomes more risky
M&M Proposition II
the proposition that a firm's cost of equity capital is a positive linear function of the firm's capital structure
M&M Proposition I
the proposition that the value of the firm is independent of the firm's capital structure
The main difference between marketed and nonmarketed claims is that marketed claims ___ be bought and sold in financial markets and nonmarketed claims ___.
can;cannot
When calculating the cash flow for a levered firm, you must consider _____.
cash flows to both bondholders and stockholders
What are some ways in which a bankruptcy filing might hinder a firm's normal business operations?
Banks may place restrictions on the firm's financial activities. Suppliers may not supply inventory, fearing nonpayment. Customers may not buy, fearing future service problems.
What is financial slack?
It is excess cash accumulated by the firm
Under M&M Proposition II with no taxes, the weighted average cost of capital is invariant to the debt level because ___.
the return on assets (RA) is unchanged
Static Theory of Capital Structure
the theory that a firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress
Voluntary arrangements to restructure a company's debt to avoid bankruptcy may be beneficial to all involved parties. This may involve _____.
extension or composition
The equity risk that comes from the financial policy or capital structure decisions of the firm is known as _____ risk.
financial
An individual can duplicate a levered firm through a strategy called ____ where the investor uses his own funds plus borrowed funds to buy stocks.
homemade leverage
The weighted average cost of capital rises at higher levels of debt owing to _____.
financial distress costs
The WACC is the cost of ______ times its weight in the capital structure plus the cost of ______ times its weight in the capital structure.
debt; equity