FIN chapter 16

Which one of the following statements is correct concerning the relationship between a levered and an unlevered capital structure? Assume there are no taxes. A. At the break-even point, there is no advantage to debt. B. The earnings per share will equal zero when EBIT is zero for a levered firm. C. The advantages of leverage are inversely related to the level of EBIT. D. The use of leverage at any level of EBIT increases the EPS. E. EPS are more sensitive to changes in EBIT when a firm is unlevered.

A) At the break-even point, there is no advantage to debt.

The concept of homemade leverage is most associated with: A. M & M Proposition I with no tax. B. M & M Proposition II with no tax. C. M & M Proposition I with tax. D. M & M Proposition II with tax. E. static theory proposition.

A) M & M Proposition I with no tax.

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.

You have computed the break-even point between a levered and an unlevered capital structure. Assume there are no taxes. At the break-even level, the: A. firm is just earning enough to pay for the cost of the debt. B. firm's earnings before interest and taxes are equal to zero. C. earnings per share for the levered option are exactly double those of the unlevered option. D. advantages of leverage exceed the disadvantages of leverage. E. firm has a debt-equity ratio of .50.

A) firm is just earning enough to pay for the cost of the debt.

M & M Proposition II with taxes: A. has the same general implications as M & M Proposition II without taxes. B. states that a firm's capital structure is irrelevant. C. supports the argument that business risk is determined by the capital structure decision. D. supports the argument that the cost of equity decreases as the debt-equity ratio increases. E. concludes that the capital structure decision is irrelevant to the value of a firm.

A) has the same general implications as M & M Proposition II without taxes.

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.

Which one of these actions generally occurs first in a bankruptcy reorganization? A. Filing proofs of claim. B. Dividing creditors into classes. C. Confirming the reorganization plan. D. Distributing cash, property, and securities to creditors. E. Submitting a reorganization plan.

A. Filing proofs of claim.

Westover Mills reduced its taxes last year by $680 by increasing its interest expense by $2,000. Which one of the following terms is used to describe this tax savings? A. Interest tax shield B. Interest credit C. Homemade leverage shield D. Current tax yield E. Tax-loss interest

A. Interest tax shield

Which one of the following states that the value of a firm is unrelated to the firm's capital structure? A. Capital Asset Pricing Model B. M & M Proposition I C. M & M Proposition II D. Law of One Price E. Efficient Markets Hypothesis

B) M & M Proposition I

Which one of the following statements related to Chapter 7 bankruptcy is correct? A. A firm in Chapter 7 bankruptcy is reorganizing its operations such that it can return to being a viable concern. B. Under a Chapter 7 bankruptcy, a trustee will assume control of the firm's assets until those assets can be liquidated. C. Chapter 7 bankruptcies are always involuntary on the part of the firm. D. Under a Chapter 7 bankruptcy, the claims of creditors are paid prior to the administrative costs of the bankruptcy. E. Chapter 7 bankruptcy allows a firm to restructure its equity such that new shares of stock are generally issued prior to the firm coming out of bankruptcy.

B) Under a Chapter 7 bankruptcy, a trustee will assume control of the firm's assets until those assets can be liquidated.

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 capital structure that maximizes the value of a firm also: A. minimizes financial distress costs. B. minimizes the cost of capital. C. maximizes the present value of the tax shield on debt. D. maximizes the value of the debt. E. maximizes the value of the unlevered firm.

B) minimizes the cost of capital.

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.

Corporations in the U.S. tend to: A. minimize taxes. B. underutilize debt. C. rely less on equity financing than they should. D. have relatively similar debt-equity ratios across industry lines. E. rely more heavily on debt than on equity as the major source of financing.

B) underutilize debt.

If a firm has the optimal amount of debt, then the: A. direct financial distress costs must equal the present value of the interest tax shield. B. value of the levered firm will exceed the value of the firm if it were unlevered. C. value of the firm is minimized. D. value of the firm is equal to VL + TC × D. E. debt-equity ratio is equal to 1.0.

B) value of the levered firm will exceed the value of the firm if it were unlevered.

Bankruptcy: A. Occurs when total equity is negative. B. Is a legal proceeding. C. Occurs when a firm cannot meet its financial obligations. D. Refers to a loss of value for debt holders. E. Is an inexpensive means of reorganizing a firm.

B. Is a legal proceeding.

Which one of the following is a marketed claim against a firm's cash flows? A. Tax payment to the IRS. B. Principal payment on long-term debt. C. Payment of employee wages. D. Payment for warranty work on a product produced by the firm. E. Payment of external legal and accounting fees.

B. Principal payment on long-term debt.

Which one of the following states that a firm's cost of equity capital is directly and proportionally related to the firm's capital structure? A. Capital Asset Pricing Model B. M & M Proposition I C. M & M Proposition II D. Law of One Price E. Efficient Markets Hypothesis

C) M & M Proposition II

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

The costs incurred by a business in an effort to avoid bankruptcy are classified as _____ costs. A. flotation B. direct bankruptcy C. indirect bankruptcy D. financial solvency E. capital structure

C) indirect 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

Homemade leverage is: A. the incurrence of debt by a corporation in order to pay dividends to shareholders. B. the exclusive use of debt to fund a corporate expansion project. C. the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage. D. best defined as an increase in a firm's debt-equity ratio. E. the term used to describe the capital structure of a levered firm.

C) the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage.

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 interest tax shield is a key reason why: A. the required rate of return on assets rises when debt is added to the capital structure. B. the value of an unlevered firm is equal to the value of a levered firm. C. the net cost of debt to a firm is generally less than the cost of equity. D. the cost of debt is equal to the cost of equity for a levered firm. E. firms prefer equity financing over debt financing.

C) the net cost of debt to a firm is generally less than the cost of equity.

The optimal capital structure: A. will be the same for all firms in the same industry. B. will remain constant over time unless the firm changes its primary operations. C. will vary over time as taxes and market conditions change. D. places more emphasis on operations than on financing. E. is unaffected by changes in the financial markets.

C) will vary over time as taxes and market conditions change.

Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, how long after a firm files for bankruptcy protection do creditors have to wait before submitting their own reorganization plan to the court? A. 60 days B. 45 days C. 180 days D. 12 months E. 18 months

C. 180 days

Which one of these statements is correct? A. Capital structure has no effect on shareholder value. B. The optimal capital structure occurs when the cost of equity is minimized. C. The optimal capital structure maximizes shareholder value. D. Shareholder value is maximized when WACC is also maximized. E. Unlevered firms have more value than levered firms when firms are profitable.

C. The optimal capital structure maximizes shareholder value.

Which one of the following statements is correct in relation to M&M Proposition II, without taxes? A. The cost of equity remains constant as the debt-equity ratio increases. B. The cost of equity is inversely related to the debt-equity ratio. C. The required return on assets is equal to the weighted average cost of capital. D. Financial risk determines the return on assets. E. Financial risk is unaffected by the debt-equity ratio.

C. The required return on assets is equal to the weighted average cost of capital.

Homemade leverage is: A. The incurrence of debt by a corporation in order to pay dividends to shareholders. B. The exclusive use of debt to fund a corporate expansion project. C. The use of personal borrowing to alter the individual's degree of financial leverage. D. Best defined as an increase in a firm's debt owed to local lenders. E. The term used to describe the capital structure of a levered firm.

C. The use of personal borrowing to alter the individual's degree of financial leverage.

Which one of the following is the equity risk that is most related to the daily operations of a firm? A. market risk B. systematic risk C. extrinsic risk D. business risk E. financial risk

D) business risk

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.

The business risk of a firm: A. depends on the firm's level of unsystematic risk. B. is inversely related to the required return on the firm's assets. C. is dependent upon the relative weights of the debt and equity used to finance the firm. D. has a positive relationship with the firm's cost of equity. E. has no relationship with the required return on a firm's assets according to M & M Proposition II.

D) has a positive relationship with the firm's cost of equity.

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

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005: A. permits creditors to file a prepack immediately after a firm files for bankruptcy protection. B. prevents creditors from submitting any reorganization plans. C. prevents firms from filing for bankruptcy protection more than once. D. permits key employee retention plans only if an employee has another job offer. E. allows firms to pay bonuses to all key employees to entice those employees to remain in the firm's employ.

D) permits key employee retention plans only if an employee has another job offer.

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

AA Tours is comparing two capital structures to determine how to best finance its operations. The first option consists of all equity financing. The second option is based on a debt-equity ratio of 0.45. What should AA Tours do if its expected earnings before interest and taxes (EBIT) are less than the break-even level? Assume there are no taxes. A. select the leverage option because the debt-equity ratio is less than 0.50 B. select the leverage option since the expected EBIT is less than the break-even level C. select the unlevered option since the debt-equity ratio is less than 0.50 D. select the unlevered option since the expected EBIT is less than the break-even level E. cannot be determined from the information provided

D) select the unlevered option since the expected EBIT is less than the break-even level

Jessica invested in Quantro stock when the firm was unlevered. Since then, Quantro has changed its capital structure and now has a debt-equity ratio of 0.30. To unlever her position, Jessica needs to: A. borrow some money and purchase additional shares of Quantro stock. B. maintain her current equity position as the debt of the firm did not affect her personally. C. sell some shares of Quantro stock and hold the proceeds in cash. D. sell some shares of Quantro stock and loan out the sale proceeds. E. create a personal debt-equity ratio of 0.30.

D) sell some shares of Quantro stock and loan out the sale proceeds.

M & M Proposition I with taxes is based on the concept that: A. the optimal capital structure is the one that is totally financed with equity. B. the capital structure of a firm does not matter because investors can use homemade leverage. C. a firm's WACC is unaffected by a change in the firm's capital structure. D. the value of a firm increases as the firm's debt increases because of the interest tax shield. E. the cost of equity increases as the debt-equity ratio of a firm increases.

D) the value of a firm increases as the firm's debt increases because of the interest tax shield.

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) weighted average cost of capital is minimized.

Based on M&M Proposition I 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.

Financial risk is: A. The risk inherent in a firm's operations. B. A type of unsystematic risk. C. Inversely related to the cost of equity. D. Dependent upon a firm's capital structure. E. Irrelevant to the value of a firm.

D. Dependent upon a firm's capital structure.

Which one of these statements related to Chapter 11 bankruptcy is correct? A. Prepacks apply only to Chapter 7, not Chapter 11 bankruptcies. B. Senior management must be replaced prior to firm exiting Chapter 11. C. A firm can only file for Chapter 11 after it becomes totally insolvent. D. Firms may file for Chapter 11 in an attempt to gain a competitive advantage. E. Chapter 11 involves the total liquidation of a firm.

D. Firms may file for Chapter 11 in an attempt to gain a competitive advantage.

Which one of the following is correct according to pecking-order theory? A. There is a direct relationship between a firm's profit and its debt levels. B. Firms avoid external debt except as a last resort. C. A firm's capital structure is independent of its need for external funding. D. Firms stockpile internally generated cash. E. There is an optimal capital structure for every firm.

D. Firms stockpile internally generated cash.

AA Tours has earnings before interest and taxes (EBIT) that are less than the break-even earnings per share level. Ignore taxes. Which one of these statements is correct given this situation if the firm wishes to improve its earnings per share? A. The firm should increase its long-term debt. B. The firm should increase its use of leverage. C. The firm should issue more equity to pay off debt. D. The firm should reduce its expenses. E. The firm should reduce its output and sales.

D. The firm should reduce its expenses.

The present value of the interest tax shield is expressed as A. (TC × D)/RA. B. VU + (TC × D). C. [EBIT × (TC × D)]/RU. D. [EBIT × (TC × D)]/RA. E. Tc × D.

E) Tc × D.

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 one of the following is the equity risk related to a firm's capital structure policy? A. market B. systematic C. extrinsic D. business E. financial

E) financial

Which one of the following makes the capital structure of a firm irrelevant? A. taxes B. interest tax shield C. 100 percent dividend payout ratio D. debt-equity ratio that is greater than 0 but less than 1 E. homemade leverage

E) homemade leverage

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

Which one of the following will generally have the highest priority when assets are distributed in a bankruptcy proceeding? A. consumer claim B. dividend payment to preferred shareholder C. company contribution to the employees' retirement account D. payment to an unsecured creditor E. payment of employee wages

E) payment of employee wages

In general, the capital structures used by U.S. firms: A. tend to overweigh debt in relation to equity. B. generally result in debt-equity ratios between 0.45 and 0.60. C. are fairly standard for all SIC codes. D. tend to be those which maximize the use of the firm's available tax shelters. E. vary significantly across industries.

E) vary significantly across industries.

The absolute priority rule determines: A. when a firm must be declared officially bankrupt. B. how a distressed firm is reorganized. C. which judge is assigned to a particular bankruptcy case. D. how long a reorganized firm is allowed to remain under bankruptcy protection. E. which parties receive payment first in a bankruptcy proceeding.

E) which parties receive payment first in a bankruptcy proceeding.

Which of the following statements are correct in relation to M & M Proposition II with no taxes? I. The required return on assets is equal to the weighted average cost of capital. II. Financial risk is determined by the debt-equity ratio. III. Financial risk determines the return on assets. IV. The cost of equity declines when the amount of leverage used by a firm rises.

I and II only

By definition, which of the following costs are included in the term "financial distress costs"? I. direct bankruptcy costs II. indirect bankruptcy costs III. direct costs related to being financially distressed, but not bankrupt IV. indirect costs related to being financially distressed, but not bankrupt

I, II, III, and IV

A firm may file for Chapter 11 bankruptcy: I. in an attempt to gain a competitive advantage. II. using a prepack. III. while allowing the current management to continue running the firm. IV. only after the firm becomes insolvent.

I, II, and III only

Which of the following statements related to financial risk are correct? I. Financial risk is the risk associated with the use of debt financing. II. As financial risk increases so too does the cost of equity. III. Financial risk is wholly dependent upon the financial policy of a firm. IV. Financial risk is the risk that is inherent in a firm's operations.

I, II, and III only

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.

I, II, and IV only

The interest tax shield has no value when a firm has a: I. tax rate of zero. II. debt-equity ratio of 1. III. zero debt. IV. zero leverage.

I, III, and IV only