Fin 302 Ch 16

Payoff to shareholders after restructuring

-Capital gains + Dividends

What are the 3 selfish strategies?

1. Incentive to take large risks 2. Incentive toward underinvestment 3. Milking the property

Implications of the pecking order theory

1. No target D/E ratio 2. Profitable firms use less debt 3. Companies like financial slack because they'll need to internally finance projects in the future

East Side, Inc. has no debt outstanding and a total market value of $136,000. Earnings before interest and taxes, EBIT, are projected to be $12,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 27 percent higher. If there is a recession, then EBIT will be 55 percent lower. East Side is considering a $54,000 debt issue with a 5 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,000 shares outstanding. Ignore taxes. If the economy enters a recession, EPS will change by ____ percent as compared to a normal economy, assuming that the firm recapitalizes. A. -70.97 percent B. -63.15 percent C. -58.08 percent D. -42.29 percent E. -38.87 percent

A. -70.97 percent

W.V. Trees, Inc. has a debt-equity ratio of 1.4. Its WACC is 10 percent, and its cost of debt is 9 percent. The corporate tax rate is 33 percent. What is the firm's unlevered cost of equity capital? A. 12.38 percent B. 12.79 percent C. 13.68 percent D. 14.10 percent E. 14.45 percent

A. 12.38 percent

M&M Proposition I with tax supports the theory that: A. a firm's weighted average cost of capital decreases as the firm's debt-equity ratio increases. B. the value of a firm is inversely related to the amount of leverage used by the firm. C. the value of an unlevered firm is equal to the value of a levered firm plus the value of the interest tax shield. D. a firm's cost of capital is the same regardless of the mix of debt and equity used by the firm. E. a firm's cost of equity increases as the debt-equity ratio of the firm decreases.

A. a firm's weighted average cost of capital decreases as the firm's debt-equity ratio increases.

Butter & Jelly reduced its taxes last year by $350 by increasing its interest expense by $1,000. Which of the following terms is used to describe this tax savings? A. interest tax shield B. interest credit C. financing shield D. current tax yield E. tax-loss interest

A. interest tax shield

The proposition that a firm borrows up to the point where the marginal benefit of the interest tax shield derived from increased debt is just equal to the marginal expense of the resulting increase in financial distress costs is called: A. the static theory of capital structure. B. M&M Proposition I. C. M&M Proposition II. D. the capital asset pricing model. E. the open markets theorem.

A. the static theory of capital structure.

If a firm issues debt and includes protective covenants in the indenture then the firm's debt will probably be issued at _____ similar debt without the covenants. A) A variable interest rate rather than the fixed rate paid on B) A lower interest rate than C) A significantly higher interest rate than D) An interest rate equal to that of E) A slightly higher interest rate than

B

One of the indirect costs of bankruptcy is the incentive toward under-investment. Under investment generally would result in: A) The firm selecting all projects with positive NPVs. B) The firm turning down positive NPV projects that would clearly be accepted if the firm were all-equity financed. C) Bondholders contributing the full amount of any new investment, but both stockholders and bondholders sharing in the benefits of those investments. D) Shareholders making decisions based on the best interests of the bondholders. E) The firm accepting more projects than it would if the probability of bankruptcy was ignored.

B

The MM theory with taxes implies that firms should issue maximum debt. In practice, this does not occur because: A) Debt is more risky than equity. B) Bankruptcy is a disadvantage to debt. C) The weighted average cost of capital is inversely related to the debt-equity ratio. D) The weighted average cost of capital is directly related to the debt-equity ratio. E) U.S. regulations require the debt-equity ratio of publicly-traded firms to be in the range of .3 to .7.

B

A firm is currently valued at $300 in a boom and $160 otherwise. The chance of a boom is 35 percent. The firm owes $200 to its debt holders. What is the value of the firm to the shareholders? A) $0 B) $35.00 C) $27.50 D) $209.00 E) $9.00

B Shareholder value = .35 × MAX[($300 - 200),0] + (1 - .35) × MAX[($160 - 200),0] = $35

Galaxy Products is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Galaxy would have 178,500 shares of stock outstanding. Under Plan II, there would be 71,400 shares of stock outstanding and $1.79 million in debt outstanding. The interest rate on the debt is 10 percent and there are no taxes. What is the breakeven EBIT? A. $287,878.78 B. $298,333.33 C. $351,111.11 D. $333,333.33 E. $341,414.14

B. $298,333.33

New Schools, Inc. expects an EBIT of $7,000 every year forever. The firm currently has no debt, and its cost of equity is 15 percent. The firm can borrow at 8 percent and the corporate tax rate is 34 percent. What will the value of the firm be if it converts to 50 percent debt? A. $31,796.47 B. $36,036.00 C. $37,407.16 D. $37,552.08 E. $38,119.30

B. $36,036.00

The unlevered cost of capital refers to the cost of capital for a(n): A. private entity. B. all-equity firm. C. governmental entity. D. private individual. E. corporate shareholder.

B. all-equity firm

Which one of the following is the legal proceeding under which an insolvent firm can be reorganized? A. restructure process B. bankruptcy C. forced merger D. legal takeover E. rights offer

B. bankruptcy

A firm should select the capital structure that: A. produces the highest cost of capital. B. maximizes the value of the firm. C. minimizes taxes. D. is fully unlevered. E. equates the value of debt with the value of equity.

B. maximizes the value of the firm.

The basic lesson of M&M Theory is that the value of a firm is dependent upon: A. the firm's capital structure. B. the total cash flow of the firm. C. minimizing the marketed claims. D. the amount of marketed claims to that firm. E. size of the stockholders' claims.

B. the total cash flow of the firm.

Bankruptcy: A. creates value for a firm. B. transfers value from shareholders to bondholders. C. technically occurs when total equity equals total debt. D. costs are limited to legal and administrative fees. E. is an inexpensive means of reorganizing a firm.

B. transfers value from shareholders to bondholders.

What's the difference between business risk and financial risk and what affects each of them?

Business risk: The risk of whether or not a firm will be able to generate enough revenue from sales to cover its operating expenses and make a profit. Things that go into sales variability, like CFs, market conditions, industry conditions, COGS, profit margins, competition, overall demand for its products, whether the firm's assets are concrete, etc. Financial risk: Deals with leverage and debt financing, so it's whether or not a company can generate enough CFs to make interest payments. Interest rate changes and the weight of debt in the company's capital structure.

One of the indirect costs of bankruptcy is the incentive for managers to take large risks. When following this strategy: A) The firm will rank all projects and select the project which results in the highest expected firm value. B) Bondholders expropriate value from stockholders by selecting high-risk projects. C) Stockholders expropriate value from bondholders by selecting high-risk projects. D) The firm will always select the lowest-risk project available. E) The firm will select only all-equity financed projects.

C

The optimal capital structure of a firm _____ the marketable claims and _____ the non-marketable claims against the cash flows of the firm. A) Minimizes; minimizes B) Minimizes; maximizes C) Maximizes; minimizes D) Maximizes; maximizes E) Equates; (leave blank)

C

Bruce & Co. expects its EBIT to be $100,000 every year forever. The firm can borrow at 10 percent. Bruce currently has no debt, and its cost of equity is 20 percent. The tax rate is 34 percent. What will the value of Bruce & Co. be if the firm borrows $54,000 and uses the loan proceeds to repurchase shares? A. $280,130 B. $346,600 C. $348,360 D. $378,900 E. $381,520

C. $348,360

The SLG Corp. uses no debt. The weighted average cost of capital is 11 percent. The current market value of the equity is $31 million and the corporate tax rate is 34 percent. What is EBIT? A. $4,180,000 B. $4,821,194 C. $5,166,667 D. $6,230,018 E. $6,568,500

C. $5,166,667

ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $480,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $240,000 and the interest rate on its debt is 9 percent. Both firms expect EBIT to be $58,400. Ignore taxes. The cost of equity for ABC is _____ percent, and for XYZ it is ______ percent. A. 12.17; 12.68 B. 12.17; 13.33 C. 12.17; 15.33 D. 12.29; 12.68 E. 12.29; 13.33

C. 12.17; 15.33

Percy's Wholesale Supply has earnings before interest and taxes of $106,000. Both the book and the market value of debt is $170,000. The unlevered cost of equity is 15.5 percent while the pre-tax cost of debt is 8.6 percent. The tax rate is 38 percent. What is the firm's weighted average cost of capital? A. 11.94 percent B. 12.65 percent C. 13.45 percent D. 14.01 percent E. 14.37 percent

C. 13.45 percent

Bruce & Co. expects its EBIT to be $100,000 every year forever. The firm can borrow at 11 percent. Bruce currently has no debt, and its cost of equity is 18 percent. The tax rate is 31 percent. Bruce will borrow $61,000 and use the proceeds to repurchase shares. What will the WACC be after recapitalization? A. 16.30 percent B. 16.87 percent C. 17.15 percent D. 18.29 percent E. 18.86 percent

C. 17.15 percent

North Side, Inc. has no debt outstanding and a total market value of $175,000. Earnings before interest and taxes, EBIT, are projected to be $16,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 30 percent higher. If there is a recession, then EBIT will be 70 percent lower. North Side is considering a $70,000 debt issue with a 7 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,500 shares outstanding. North Side has a tax rate of 34 percent. If the economy expands strongly, EPS will change by ____ percent as compared to a normal economy, assuming that the firm recapitalizes. A. 38.80 percent B. 41.26 percent C. 43.24 percent D. 50.45 percent E. 53.92 percent

C. 43.24 percent

M&M Proposition II is the proposition that: A. the capital structure of a firm has no effect on the firm's value. B. the cost of equity depends on the return on debt, the debt-equity ratio, and the tax rate. C. a firm's cost of equity is a linear function with a slope equal to (RA - RD). D. the cost of equity is equivalent to the required rate of return on a firm's assets. E. the size of the pie does not depend on how the pie is sliced.

C. a firm's cost of equity is a linear function with a slope equal to (RA - RD).

The explicit costs, such as legal and administrative expenses, associated with corporate default are classified as _____ costs. A. flotation B. issue C. direct bankruptcy D. indirect bankruptcy E. unlevered

C. direct bankruptcy

A firm is technically insolvent when: A. it has a negative book value. B. total debt exceeds total equity. C. it is unable to meet its financial obligations. D. it files for bankruptcy protection. E. the market value of its stock is less than its book value.

C. it is unable to meet its financial obligations.

A business firm ceases to exist as a going concern as a result of which one of the following? A. divestiture B. share repurchase C. liquidation D. reorganization E. capital restructuring

C. liquidation

M&M Proposition I with no tax supports the argument that: A. business risk determines the return on assets. B. the cost of equity rises as leverage rises. C. the debt-equity ratio of a firm is completely irrelevant. D. a firm should borrow money to the point where the tax benefit from debt is equal to the cost of the increased probability of financial distress. E. homemade leverage is irrelevant.

C. the debt-equity ratio of a firm is completely irrelevant.

The optimal capital structure will tend to include more debt for firms with: A) The highest depreciation deductions. B) The lowest marginal tax rate. C) Substantial tax shields from other sources. D) Lower probability of financial distress. E) Less taxable income.

D

The value of a firm is maximized when the: A) Cost of equity is maximized. B) Tax rate is zero. C) Levered cost of capital is maximized. D) Weighted average cost of capital is minimized. E) Debt-equity ratio is minimized.

D

A firm has debt of $12,000, a leveraged value of $26,400, a pre-tax cost of debt of 9.20 percent, a cost of equity of 17.6 percent, and a tax rate of 37 percent. What is the firm's weighted average cost of capital? A. 11.47 percent B. 11.52 percent C. 11.69 percent D. 12.23 percent E. 12.48 percent

D. 12.23 percent

Which of the following are correct according to pecking-order theory? I. Firms stockpile internally-generated cash. II. There is an inverse relationship between a firm's profit level and its debt level. III. Firms avoid external debt at all costs. IV. A firm's capital structure is dictated by its need for external financing. A. I and III only B. II and IV only C. I, III, and IV only D. I, II, and IV only E. I, II, III, and IV

D. I, II, and IV only

Based on M&M Proposition II with taxes, the weighted average cost of capital: A. is equal to the aftertax cost of debt. B. has a linear relationship with the cost of equity capital. C. is unaffected by the tax rate. D. decreases as the debt-equity ratio increases. E. is equal to RU × (1 - TC).

D. decreases as the debt-equity ratio increases.

Which one of the following has the greatest tendency to increase the percentage of debt included in the optimal capital structure of a firm? A. exceptionally high depreciation expenses B. very low marginal tax rate C. substantial tax shields from other sources D. low probabilities of financial distress E. minimal taxable income

D. low probabilities of financial distress

Edwards Farm Products was unable to meet its financial obligations and was forced into using legal proceedings to restructure itself so that it could continue as a viable business. The process this firm underwent is known as a: A. merger. B. repurchase program. C. liquidation. D. reorganization. E. divestiture.

D. reorganization.

Pecking order theory definition and rules

Definition: The cost of financing increases with asymmetric info. Rules: 1. Use internal financing as much as possible 2. If outside financing is needed, debt should be issued before equity

In a world with taxes and financial distress, when a firm is operating with the optimal capital structure the: A) Debt-equity ratio will be less than optimal. B) Weighted average cost of capital will be maximized. C) Firm will be all-equity financed. D) Required return on assets will be at its maximum point. E) Increased benefit from additional debt is equal to the increased bankruptcy costs of that debt.

E

In general, the capital structures used by U.S. firms: A) Tend to overweight debt in relation to equity. B) Are easily explained in terms of earnings volatility. C) Are easily explained by analyzing the types of assets owned by the various firms. D) Tend to be those which maximize the use of the firm's available tax shelters. E) Vary significantly across industries.

E

Indirect costs of financial distress: A) Effectively limit the amount of equity a firm issues. B) Serve as an incentive to increase the financial leverage of a firm. C) Include costs such as legal and accounting fees. D) Tend to increase as the debt-equity ratio decreases. E) Include the costs incurred by a firm as it tries to avoid seeking bankruptcy protection.

E

The optimal capital structure has been achieved when the: A) Debt-equity ratio is equal to 1. B) Weight of equity is equal to the weight of debt. C) Cost of equity is maximized given a pretax cost of debt. D) Debt-equity ratio is such that the cost of debt exceeds the cost of equity. E) Debt-equity ratio selected results in the lowest possible weighed average cost of capital.

E

Lamont Corp. uses no debt. The weighted average cost of capital is 11 percent. The current market value of the equity is $38 million and there are no taxes. What is EBIT? A. $3,423,000 B.$3,508,600 C. $3,781,100 D. $3,898,700 E. $4,180,000

E. $4,180,000

Young's Home Supply has a debt-equity ratio of 0.80. The cost of equity is 14.5 percent and the aftertax cost of debt is 4.9 percent. What will the firm's cost of equity be if the debt-equity ratio is revised to 0.70? A. 10.89 percent B. 11.47 percent C. 11.70 percent D. 13.89 percent E. 13.97 percent

E. 13.97 percent

The optimal capital structure has been achieved when the: A. debt-equity ratio is equal to 1. B. weight of equity is equal to the weight of debt. C. cost of equity is maximized given a pre-tax cost of debt. D. debt-equity ratio is such that the cost of debt exceeds the cost of equity. E. debt-equity ratio results in the lowest possible weighted average cost of capital.

E. debt-equity ratio results in the lowest possible weighted average cost of capital.

The static theory of capital structure advocates that the optimal capital structure for a firm: A. is dependent on a constant debt-equity ratio over time. B. remains fixed over time. C. is independent of the firm's tax rate. D. is independent of the firm's weighted average cost of capital. E. equates the tax savings from an additional dollar of debt to the increased bankruptcy costs related to that additional dollar of debt.

E. equates the tax savings from an additional dollar of debt to the increased bankruptcy costs related to that additional dollar of debt.

Which form of financing do firms prefer to use first according to the pecking-order theory? A. regular debt B. convertible debt C. common stock D. preferred stock E. internal funds

E. internal funds

Which one of the following is a direct bankruptcy cost? A. company CEO's time spent in bankruptcy court B. maintaining cash reserves C. maintaining a debt-equity ratio that is lower than the optimal ratio D. losing a key company employee E. paying an outside accountant fees to prepare bankruptcy reports

E. paying an outside accountant fees to prepare bankruptcy reports

R0

Expected earnings to unlevered firm/Unlevered equity

Tradeoff theory

There's a tradeoff between the tax benefits of debt and the costs of financial distress

With corporate taxes and bankruptcy costs, the firm value is maximized where the ____________________________ from the _______________________ is _____________________ by the _______________ in ______________________________.

Where the additional benefit from the interest tax shield is just offset by the increase in expected bankruptcy costs