FIN 3060 Chapters 12-14

Rank each of the following in order of priority of payment. bankruptcy administrative expenses consumer claims wages, salaries, and commissions payment to common shareholders

1. bankruptcy administrative expenses 2. wages, salaries, and commissions 3. consumer claims 4. payment to common shareholders

Based on M&M Proposition I with corporate taxes, the optimal capital structure is ______.

100%

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

Airlines & Cable television

Which of the following is true about stock dividends and stock splits?

Both will increase the total number of shares. Both will reduce the share price.

Which of the following industries tend to have a low leverage?

Computers & Drugs

The formula for calculating the cost of equity capital that is based on the dividend discount model is ______.

D1/P0 + g

Which costs of financial distress are easier to measure?

Direct costs are easy to measure.

True or false: In the WACC calculation, V = E − D.

False - V = E + D

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

False - equity still carries risk; thus, an investor should expect a higher return than that on less risky debt

True or false: The SML approach is advantageous because all it requires is estimation of beta.

False - estimation of beta is not required for the SML approach

True or false: According to the CAPM, if the market risk premium is zero, then the expected return on a stock is equal to the required return.

False - it is equal to risk-free rate

True or false: The cost of capital depends on the source of the funds.

False - the cost of capital depends on the use of the funds.

True or false: Stockholders care most about the dividend maximization of the firm.

False - they care most about maximizing the overall value of the firm

True or false: Under current law, a repurchase has not advantage over a cash dividend.

False - under current law, a repurchase has significant tax advantage over a cash dividend

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.

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.

Accounting for the time value of money, which of the following is true of an increase in dividend payout at a point in time?

The net effect is zero. It is exactly offset by a decrease somewhere else.

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

What is the appropriate discount rate to use only if the proposed investment is a replica of the firm's existing operating activities?

WACC

If a firm has multiple projects, each project should be discounted using ______.

a discount rate commensurate with the project's risks

Which of the following is tax-deductible to the firm?

coupon interest paid on bonds

Bankruptcy costs may exceed the tax shield benefits of __________

debt

True or false: When total book liabilities exceed the book value of the total assets, a firm is said to have reached fallen angel insolvency.

false - it has reached accounting insolvency when book liabilities exceed the book value of total assets

True or false: Based on M&M Proposition I, even including taxes, capital structure does not matter to the firm.

false - once taxes are included, capital structure matters

True or false: Conglomerates are companies that specialize only in projects similar to the project your firm is considering.

false - pure plays are companies that specialize only in projects similar to the project your firm is considering

True or false: The expected percentage is the overall rate of return the firm must earn on its existing assets to maintain the value of its stock.

false - the WACC is the overall rate of return the firm must earn on its existing assets to maintain the value of its stock

True or false: The discount rate is also known as the expected return.

false: it is known as the required return, appropriate discount rate, and cost of capital

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

How is the optimal debt level determined?

in a subjective manner

Earnings per share will _______ and total earnings will remain unchanged under a share repurchase.

increase or rise

Components of the WACC include funds that come from ______ .

investors

Which of the following are direct costs of financial distress?

legal fees & administrative expenses

M&M Proposition I does not work with corporate taxes because ______.

levered firms pay lower taxes than unlevered firms

What are some examples of indirect financial distress costs?

lost sales & lost reputation

The cost of debt is generally ________ than the cost of equity.

lower

According to the survey discussed in the text, the highest priority for financial managers is to ______.

maintain a consistent dividend policy

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

True or false: Projects should always be discounted at the firm's overall cost of capital.

False- projects' discount rates should reflect their particular level of risk

______ is the term that describes the capital structure when debt is used to finance assets.

Financial leverage

Which of the following statements are true regarding the effect of financial leverage and the firm's operating earnings (EBIT)?

The rate of return on assets is unaffected by leverage.

True or False: the market value of debt and equity are not reliable in case of privately owned company

True

A reverse stock split results in

a higher share price an investor owning fewer shares

Which of the following involves a firm distributing stock instead of cash to its owners?

a stock split & a stock dividend

The discount rate for the firm's projects equals the cost of capital for the firm as a whole when ______.

all projects have the same risk as that of the firm overall

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

assets

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

bad for the firm

If there are no taxes or flotation costs, then investors will ______.

be indifferent between dividends and a repurchase

Some risk adjustment to a firm's WACC for projects of differing risk, even if it is subjective, is probably ______.

better than no risk adjustment

The equity risk that comes from the nature of a firm's operating activities is known as ______.

business risk

Dividends paid to common stockholders ______ be deducted from the payer's taxable income for tax purposes.

cannot

Which of the following are components used in the construction of the WACC?

cost of common stock, cost of debt, and cost of preferred stock

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 date on which the company's Board of Directors passes a resolution to pay a dividend is called the ______ date.

declaration

The cost of debt will begin to increase as the ______.

degree of leverage increases

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

direct costs indirect costs

The optimal level of debt in the presence of corporate taxes and bankruptcy costs occurs at the point at which the present value of distress costs ______ the present value of the tax shield benefits.

equals

If the firm is all-equity, the discount rate is equal to the firm's cost of ______ capital.

equity

The date that establishes those individuals entitled to a declared dividend is called the ______.

ex-dividend date

The tax deductibility of interest payments is ______.

good for the firm

To a tax-paying stockholder, a stock repurchase ______.

has significant tax advantages compared to a cash dividend

A capital restructuring may include ______.

issuing more debt issuing more equity issuing debt and repurchasing equity

The possibility of bankruptcy costs has a(n) ______ effect on the value of the firm.

negative

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

negative EBIT & losses carried forward

In the United States, dividends received have historically been taxed as ______.

ordinary income

The date the firm mails out its declared dividends is called the:

payment date.

A company may consider a reverse stock split for which of the following reasons?

to reduce transaction costs to investors to increase the share price to a "respectable" level to increase liquidity to meet exchange listing requirements

If a firm uses its overall cost of capital to discount cash flows from projects in higher risk divisions, it will accept ______ projects.

too many

True or false: According to the absolute priority rule, administrative expenses associated with the bankruptcy are paid first in the distribution of the proceeds of liquidation.

true

True or false: One disadvantage of dividends is that they are taxed to recipients.

true

True or false: ideally, we should use market values in the WACC

true

The cost of capital depends primarily on the ______ of funds, not the ______.

use; source

The WACC is the overall rate of return the firm must earn on its existing assets to maintain the _________ of its stock.

value

For a firm with outstanding debt, the cost of debt will be the ______ on that debt.

yield to maturity

Which of the following is true about a firm's cost of debt?

yields can be calculated from observable data and it is easier to estimate than the cost of equity

Which of the following assumptions is necessary for M&M Proposition I to hold?

Individuals can borrow on their own at an interest rate equal to that of the firm.

What will happen over time if a firm uses its overall WACC to evaluate all projects, regardless of each project's risk level?

It will accept projects that it should have rejected, the firm overall will become riskier, and it will reject projects that it should have accepted.

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

M&M demonstrated that debt financing is neither better nor worse than equity financing. & The asset to be financed is the same.

Which of the following are reasons why investors might favor a high dividend payout?

There is a preference for tax and legal benefits from high dividends. Transaction costs for selling low dividend stocks can be avoided. There is a preference for current income.

True or false: Firm value is maximized when the WACC is minimized.

True

True or false: If there are no imperfections, then a cash dividend and a share repurchase are essentially the same thing.

True

True or false: M&M demonstrated that debt financing is neither better nor worse than equity financing.

True

True or false: The return an investor in a security receives is equal to the cost of the security to the company that issued it.

True

True or false: Dividend policy is irrelevant.

True - dividend policy merely establishes the trade-off between dividends at one date and dividends at another date

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

True - the present value of distress costs can exceed the present value of tax savings at very high levels of debt

An investor who invests in the stock of a levered firm rather than in an all-equity firm will require ______.

a higher expected return

The rate used to discount project cash flows is known as the ______.

discount rate, cost of capital, and the required return

A strong argument can be made that:

dividend policy does not matter.

A firm can pay out its cash earnings to its shareholders in which of the following ways?

dividends share repurchase

What can we say about the dividends paid to common and preferred stockholders?

dividends to common stockholders are not fixed and dividends to preferred stockholders are fixed

According to M&M Proposition I, a firm's capital structure choices ______.

do not affect the value of the firm

The return an investor in a security receives is ______ the cost of the security to the company that issued it.

equal to

The value of a levered firm will be _______ than the value of an identical unlevered firm because the levered firm's taxes will be _________.

higher ; lower

Customers refusing to buy GM cars when the company filed for Chapter 11 for fear of not being able to get service for the cars in the future is an example of ______ costs of financial distress.

indirect

Bankruptcy is very valuable because ______.

it can be used strategically to improve a firm's competitive position & payments to creditors cease pending the outcome of the bankruptcy process

Finding a firm's overall cost of equity is difficult because ______.

it cannot be observed directly

A firm that pays cash dividends is signaling ______ and ______.

it expects to continue to be profitable it is not hoarding too much cash

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

it magnifies gains and losses

If a firm issues no debt, its average cost of capital will equal ______.

its cost of equity - because the weight of equity in this case is 100%, the weighted average cost of capital is the cost of equity

Financial distress can arise in the form of possible ______.

legal bankruptcy & business failure

What is generally the most important component of direct bankruptcy costs?

legal costs

Preferred stock __________.

pays dividends in perpetuity and pays a constant dividend

Other companies that specialize only in projects similar to the project your firm is considering are called ______.

pure plays

If an all-equity firm discounts a project's cash flows with the firm's overall weighted average cost of capital even though the project's beta is less than the firm's overall beta, it is possible that the project might be ___________.

rejected, when it should be accepted.

Relatively young firms should consider a dividend policy aimed at ______ .

retaining earnings to reinvest in the firm

The WACC of a firm reflects the _______ and the target capital structure of the firm's existing assets as a whole.

risk

Volatility or ______ increases for equity holders when leverage increases.

risk

The growth rate of dividends can be found using _________.

security analysts' forecasts and historical dividend growth rates

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

An alternative way to pay out a firm's earnings to shareholders instead of cash dividends is a ______.

stock repurchase

It is difficult to establish discount rate for individual projects, so firms often adopt an approach that involves making _______ adjustments to the overall WACC.

subjective

The optimal capital structure is sometimes known as:

target capital structure

How does the level of debt affect the weighted average cost of capital (WACC)?

the WACC initially falls and then rises as debt increases

SmartKids, a textbook publisher, is considering investing in a software company that collects and stores data. What beta should SmartKids use to assess the risk of the project?

the beta software companies that collect and store data

The concept that stocks attract certain investors due to a firm's dividend policy and the resulting tax impact is called ______.

the clientele effect

M&M Proposition II shows that ______.

the cost of equity rises with leverage

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

the firm's value is maximized

Under M&M Proposition II, a firm's WACC remains unchanged regardless of changes in its capital structure because as the % of debt increases ______.

the increase in the cost of both debt and equity is exactly offset by the increase in the % of lower cost debt

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

the interest tax shield

To estimate the dividend yield of a particular stock, we need ______.

the last dividend paid (Do), forecasts of the dividend growth rate (g), and the current stock price

The WACC is the minimum required return for ______.

the overall firm

According to the CAPM, what is the expected return on a stock if its beta is equal to zero?

the risk-free rate

Dividend policy can best be described as the:

time pattern of dividend payout