FIN CHP 13

Which one of the following statements is correct?

Bankruptcy courts have "cram-down" powers.

the effect of leverage depends on

EBIT *when EBIT is higher, leverage is more beneficial

with a BREAK EVEN EBIT

EPS IS THE SAME FOR BOTH CAPITAL STRUCTURES

REORGANIZATION BANKRUPTCY (CHP 11)

Federal bankruptcy reform act of 1978 - petition filed by firm or creditors - usually, firm continues operations as "debtor in possession" - firm submits reorganization plan - if accepted by classes of creditors, then confirmed by court - firm makes payments to creditors and operates under plan for some fixed time

LIQUIDATION BANKRUPTCY (CHP 7)

Federal bankruptcy reform act of 1978 - petition filed in federal court - trustee elected by creditors to take over firms assets - trustee attempts to sell assets - proceeds distributed according to the absolute priority rule

Which one of the following terms is inclusive of both direct and indirect bankruptcy costs?

Financial distress costs

Which one of the following statements concerning financial leverage is correct?

Financial leverage magnifies both profits and losses.

Which of the following statements correctly relate to M&M Proposition I, with taxes? I. Debt decreases the value of a firm. II. The levered value of a firm exceeds the firm's unlevered value. III. The weighted average cost of capital (WACC) is constant. IV. The optimal capital structure is zero debt.

II Only

Which one of the following terms applies to the costs incurred by a firm which is trying to avoid filing for bankruptcy?

Indirect bankruptcy costs

Which one of the following is a direct bankruptcy cost?

Legal and accounting fees related to a bankruptcy proceeding

Gabe's Market is comparing two different capital structures. Plan I would result in 11,000 shares of stock and $225,000 in debt. Plan II would result in 14,000 shares of stock and $150,000 in debt. The interest rate on the debt is 8 percent. Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $45,000. The all-equity plan would result in 20,000 shares of stock outstanding. Of the three plans, the firm will have the highest EPS with _____ and the lowest EPS with ____

Plan I; all-equity plan

shareholders are exposed to more risk with more leverage

ROE and EPS are more sensitive to changes in EBIT when a firm is using debt

Greenwood Motels has filed a petition for bankruptcy but hopes to continue its operations both during and after the bankruptcy process. Which one of the following terms best applies to this situation?

Reorganization

the firm borrows up to the point that the extra benefit from an extra $ in debt is exactly equal to the cost that comes from the increased probability of financial distress

STATIC THEORY OF CAPITAL STRUCTURE

Which one of the following is minimized when the value of a firm is maximized?

WACC

According to M&M Proposition 2, when there are only taxes and no bankruptcy costs,

WACC decreases and cost of equity increases

When is a firm insolvent from an accounting perspective?

When the firm has a negative net worth

causing bankruptcy to be expensive and slow: Section 363

auction-like bankruptcy

accounting insolvency

book value of equity is negative

Which one of the following is the equity risk arising from the daily operations of a firm?

business risk

business failure

businesses terminated with a loss to creditors

Capital Restructuring=

changing the amount of leverage WITHOUT CHANGING THE FIRMS ASSETS

leverage increases, risk increases,

cost of equity increases

M&M Proposition II, without taxes, states that the:

cost of equity increases as a firm increases its debt-equity ratio.

causing bankruptcy to be expensive and slow: cram-downs

court-ordered plan acceptance

when the value of the firms assets equals the value of the firms debt then the firm is

economically bankrupt in the sense that the equity has no value

Which one of the following is the equity risk arising from the capital structure selected by a firm?

financial risk

technical insolvency

firm unable to meet debt obligations

the higher the tax rate,

greater incentive to use debt

The use of borrowing by an individual to adjust his or her overall exposure to financial leverage is referred to as:

homemade leverage.

Under the "expected" scenario leverage

increases ROE and EPS

Variability in both ROE and EPS increase when financial leverage

is increased

A prepack:

is the joint filing of both a bankruptcy filing and a creditor-approved reorganization plan.

direct bankruptcy costs

legal and administrative costs - quantifiable - measurable *Bondholders incur additional losses - because of expenses associated with the process, bondholders won't get all they are owed

Which one of the following terms refers to the termination of a firm as a going concern?

liquidation

capital structures differ by industries

lowest: computer equipment, drugs highest: pay television, airlines

the primary goal of financial managers:

maximize stockholder wealth

causing bankruptcy to be expensive and slow: workouts

negotiated extensions or payments

capital structure

percent of debt and equity used to fund the firms assets

legal bankruptcy

petition filed in federal court for bankruptcy

causing bankruptcy to be expensive and slow: prepacks

prepackaged filings

Modigliani and Miller capital structure theory

proposition I: the pie model proposition II: risk free and financial leverage

Homemade leverage

suggests there is nothing special with corporate borrowing * any stockholder who prefers leverage can create their own "homemade" leverage and replicate the payoffs - you are taking on the debt by yourself

ANNUAL INTEREST TAX SHIELD

tax rate times interest payment $1000 in 8% debt = $80 in interest expense annual tax shield= .25(80)= 20 every year

The tax benefit is only important if

the firm has a large tax liability

the greater the risk of financial distress,

the less debt will be optimal for the firm

Case I: No corporate or personal taxes and no bankruptcy costs

the pie model: the value of the firm is not affected by changes in the capital structure, the cash flows are not changing risk free and financial leverage - the WACC of the firm is not affected by capital structure

As the D/E ratio increases,

the probability of bankruptcy increases. - This increased probability will increase the expected bankruptcy costs.

proposition II: risk free and financial leverage

the systemtice risk of the stock depends on * systematic risk of assets Ra (business risk) * level of leverage D/E (financial risk)

"leverage"

the use of debt in capital structure

According to M&M Proposition 1, when there are only taxes and no bankruptcy costs,

the value of the firm increases as total debt increases because of the interest tax shield

if we expect EBIT to be GREATER than the break-even point

then leverage is beneficial to our stockholders

if we expect EBIT to be LESS than the break-even point

then leverage is detrimental to our stockholders

Modigliani and Miller capital structure theory The value of the firm is determined by the cash flows to the firm and the risk of the firms assets

to change firm value - change the risk of cash flows - change the cash flows

leveraging affects variability on ROE

when D/E= 1 the highs are higher and the lows are lower for ROE between a recession and expansion than when using all equity

leveraging affects variability on EPS

when D/E=1 highs are higher and lows are lower than between a recession and expansion than when using all equity

Interest on debt is tax deductible

when a firm adds debt, it reduces taxes all else equal * this reduction of taxes INCREASES THE CASH FLOW OF THE FIRM

LIQUIDATION BANKRUPTCY (CHP 7)

where businesses end not all creditors rank on the same level

present value of annual interest tax shield

*assume perpetual debt PV= 20/.08= 250

leverage amplifies the variation in both

- EPS (ni/shares outstanding) - ROE (ni/te)

THE STRATEGIC VALUE OF THE RIGHT TO FILE BANKRUPTCY

- IMMEDIATE "STAY" ON CREDITORS - ABILITY TO TERMINATE LABOR AGREEMENTS - ABILITY TO LAY OFF LARGE NUMBERS OF WORKERS - ABILITY TO REDUCE WAGES

indirect bankruptcy costs

- LARGER THAN DIRECT COSTS, but more difficult to measure and estimate - stockholders want to avoid a formal bankruptcy - bondholders want to keep existing assets intact so they can at least receive that money - assets lose value as management spends time worrying about avoiding bankruptcy instead of running the business - lost sales, interrupted operations and loss of valuable employees, low morale, inability to purchase goods on credit

Capital Restructuring:

- increase leverage by issuing debt and repurchasing outstanding shares - decrease leverage by issuing new shares and retiring debt

maximizing shareholder wealth equals...

- maximizing firm value - minimizing WACC *objective: choose the capital structure that will minimize WACC and maximize shareholder wealth

Which one of the following best defines legal bankruptcy?

A legal proceeding for liquidating or reorganizing a business

In the process of liquidation, some types of claims receive preference over other claims. Which one of the following determines which type of claim is paid first?

Absolute priority rule

Which one of the following statements concerning financial leverage is correct?

Changes in the capital structure of a firm will generally change the firm's earnings per share.

Observed Capital Structures. Which of the following is not correct?

The more capital intensive industries, such as airlines, cable television, and electric utilities, tend to use less financial leverage