Corporate Finance for Managers CH. 13 Studyguide

Based on MM Proposition I with corporate taxes, the optimal capital structure is ________.

100% debt

A capital restructuring may include

- issuing more equity - issuing debt and repurchasing equity - issuing more debt

What are some examples of indirect financial distress costs?

- lost reputation - lost sales

An optimal capital structure will

- maximize the value of the firm - minimize the cost of capital

The tax shield afforded by debt will be of the least use to firms with

- negative EBT - losses carried forward

Rank each of the following in order of priority of payment.

1 -Bankruptcy administrative expenses 2 - Wages, salaries, and commissions 3 - Consumer claims 4 - Payment to common shareholders

Alpha Co. has a debt-equity ratio of .6, a pretax cost of debt of 7.5 percent, and an unlevered cost of equity of 12 percent. What is Alpha's cost of equity if you ignore taxes?

14.7% 12% + 0.6 (12% - 7.5)

Which costs of financial distress are easier to measure?

Direct costs

True or false: Holding equity in an unlevered firm has no risk.

False

True or false: There is a precise mathematical equation for determining the optimal value of debt for any firm.

False. The optimal debt level is determined in a subjective manner, there is no precise equation.

____ is the term that describes the capital structure when debt is used to financial assets.

Financial leverage

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.

Which of the following is true of the impact of financial leverage?

It magnifies gains and losses

True or false: It is possible for the present value of distress costs to exceed the present value of tax savings.

True

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

The fact that failure to meet debt obligations can result in bankruptcy is _________.

bad for the firm

The value of a levered firm is higher than the value of an unlevered firm in the presence of corporate taxes owing to the tax shield benefit of:

debt

The cost of debt will begin to increase as the:

degree of leverage increases

Which of the following are direct costs of financial distress?

- Administrative expenses - Legal fees

Financial distress can arise in the form of possible:

- Business failure - Legal bankruptcy

Which of the following industrues tend to have a high leverage?

- Cable television - Airlines

Which two of the following are broad types of costs of Financial distress?

- Direct costs - Indirect costs

According to MM Proposition 1, the value of a firm is the same for debt financing as it is for equity financing because of which of the following?

- MM demonstrated that debt financing is neither better nor worse than equity financing - The asset to be financed is the same

Bankruptcy is very valuable because:

- Payments to creditors cease pending the outcome of the bankruptcy process. - It can be used strategically to improve a firm's competitive position.

A corporation gains no value from an interest tax shield if which of the following are true?

- The corporation is an all-equity firm. - Corporate tax rates are zero. - The corporation has no debt.

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

M&M Proposition I states if the assets and operations (left-hand side of the balance sheet) for two firms are the same, then ___________ .

- The value of the two firms is equal - How the firms are financed is irrelevant

The costs of financial distress depend mostly on how easily the ownership of the firm's ___ can be transferred.

assets

The weighted average cost of capital rises at higher levels of debt owing to:

financial distress costs

An investor who buys the common stock of a levered firm is subject to more risk due to the addition of

financial risk

The equity risk that comes from the financial policy or capital structure decisions of the firm is known as:

financial risk

With __________ _________, an investor is able to replicate a corporation's capital structure by borrowing funds and using those funds along with their own money to buy the company's stock.

homemade leverage

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

Volatility or ____ increases for equity holders when leverage increases.

risk

The idea that a firm borrows to the point that the tax benefit of debt is exactly equal to the increased probability of financial distress is called the _______ theory of capital structure.

static

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.

A beneficial rule to follow is to set the firm's capital structure so that ___.

the firm's value is maximized

The Static Theory of Capital Structure suggests employing debt to the point that its cost equals the cost of _____________________.

the increased probability of bankruptcy

The tax savings attained by a firm from the tax deductibility of interest expense is called

the interest tax shield

A firm is considered bankrupt when the value of its equity is ___.

zero

Which of the following will apply when a firm's debt levels are extremely high?

✔ the benefits of debt financing may be more than offset by the costs of financial distress ✔ the possibility of financial distress will become a chronic problem