Ch 16

Ace your homework & exams now with Quizwiz!

Care Corporation has issued both debt and equity. It has an annual debt obligation of $30 toward interest and principal. Care corporation is forecasting a cash flow of either $25 (scenario 1) or $50 (scenario 2) in the coming year. What will be the payment to bondholders in the two scenarios?

$25 in scenario 1 and $30 in scenario 2

If ABC Co. has earnings before interest and taxes of $2 million with debt of $5 million, what is the total cash flow to bondholders and stockholders of the interest rate is 10 percent and the tax rate is 21 percent?

(.1 * $5mil) + [$2mil(.1 * $5mil)(1-.21) = $1,685,000

Under the MM proposition with no taxes, managers cannot change the value of the firm by repackaging its securities because

-as debt is added, the equity becomes more risky -the overall cost of capital cannot be reduced

What are some ways in which a bankruptcy filing might hinder a firm's normal business operations?

-banks may place restrictions on the firm's financial activities -customers may not buy, fearing future service problems -suppliers may not supply inventory, fearing nonpayment

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

-cable television -airlines

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

What are the advantages of using internal financing?

-it may be cheaper than debt or equity issues -it prevents the adverse market reaction that tends to accompany a stock issue

Which of the following will apply when a firm's debts 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 -the corporation has no debt -corporate tax rates are zero

Which of the following are generally true about the cost of equity and the cost of debt?

-the cost of equity may increase with leverage -the cost of debt is generally lower than the cost of equity -the cost of debt increases with leverage

Which of the following are consequences of nonpayment of debt obligations?

-the firm will encounter some form of financial distress -a firm may be forced to file for bankruptcy

Omega Corp. has $20 mil in perpetual debt outstanding with a coupon rate of 8%. The tax rate is 21%. What is the present value of the tax shield?

.21 * $20 mil = $4.2 mil

Rank in order of priority of payment starting with the highest priority to lowest priority.

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

Solid Rock is an unlevered firm with an EBIT of $10 million and an unlevered cost of capital of 12%. If the tax rate is 21%, what is the value of the firm?

65.83 million $10mil(1-.21)/.12 = 65.83 mil

Stockholders and bondholders:

Are not the only claimants to the cash flows of the firm

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

Assets

Under pecking order theory, firms can choose between debt or financing for external financing, which will they prefer?

Debt

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

Direct and indirect

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

Indirect

Which of the following assumptions is necessary for the MM Proposition to hold?

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

The manager of a firm should change the capital structure if and only if

It increases the value of the firm

What is generally the most important component of direct costs?

Legal Costs

which of the following are non marketed claims to the firms cash flows?

Legal fees and taxes

The risk of too much ____ is bankruptcy

Leverage

MM 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 and lost reputation

The point at which the tax saving from an additional dollar in debt financing is exactly balanced by the increased costs of bankruptcy associated with additional borrowing is the essence of the:

Static theory of capital structure

How does the level of debt affect the WACC?

The WACC initially falls and then rises as debt increases

It is often in everyone's best interest to decide a "workout" strategy that avoids bankruptcy because

The bankruptcy process can be long and expensive

Which of the following is likely to be true when a bankruptcy ruling is issued?

The ownership of assets is transferred from the shareholders to the bondholders

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

higher expected return

MM Proposition II shows that

the cost of equity rises with leverage

Place the steps needed to calculate the value of a levered firm with perpetual cash flows in order starting with the first step

1. Calculate EBIT 2. Multiply EBIT by 1 minus the corporate tax rate 3. Divide by the cost of equity for an all-equity firm 4. Add the present value of the debt tax shield

A firm has $5,000 of debt, $16,000 of equity, a cost of debt of 8 percent, and a cost of equity of 12%. What is the firm's WACC if there are no taxes?

11.05% (16000/21000)x12%+(5000/21000)x8%=11.05%

If the current share price of an all-equity firm is $25, going to a capital structure with 50% debt and 50% equity will result in a new share price of _____ when ignoring the impact of taxes

25

What is the preferred source of financing for firms according to the pecking-order theory?

1. Retained earnings 2. Debt 3. Common stock

An individual can duplicate a levered firm through a strategy called ____ where the investor uses his own funds plus borrowed funds to buy stocks

Homemade leverage

Why is MM's assertion about the positive relationship between firm value and leverage not observed in the real world?

MM did not consider bankruptcy costs

A company should select a capital structure that

Maximizes the company's value

The value of the firm is maximized when the weighted average cost of capital (WACC) is:

Minimized

The expected return on equity is ____ to leverage

Positively related

What is the effect of possible bankruptcy costs on the value of a firm?

They reduce the value of the firm

Which costs of financial distress are easier to measure?

Direct costs

The value of the firm is given by the following expression:

Firm value = value of equity + value of debt

An unlevered firm

Has an all-equity capital structure

The cost of equity is generally

Higher than the cost of debt

Which capital structure theory suggests that profitable firms will use less debt?

The pecking-order theory

What are the two components of the static theory?

The tax benefits of debt and the costs of financial distress

MM Proposition I (with taxes)

The total value of the levered firm exceeds the value of the firm without leverage due to the present value of the tax savings from debt.

What do Modigliani and Miller assert about the relationship between leverage and firm value in the presence of corporate taxes?

The value of the firm increases with leverage

a beneficial rule to follow is to set the firms capital structure so that

the firm's value is maximized

In absence of taxes, the value of a firm is the same with debt financing as it is with equity financing because

-MM demonstrated that debt financing is neither better nor worse than equity financing in the absence of taxes -the asset to be financed is the same

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

-the rate of return on assets is unaffected by leverage -below the indifference or break-even point in EBIT, an unlevered capital structure is best -financial leverage increases the slope of the EPS line


Related study sets

Pediatrics Exam 2: Wong Chapters 1, 2, 3, 11, 12, 17-20

View Set

Insurance Regulations - B. State Regulation

View Set

CLIPP cases - End of case Questions

View Set

Field Tech III - IV Conventional-TCP/IP SERVICES (190E50-3)

View Set

3 Staying in Hotels (Top Notch 2)

View Set

Ch: 1 Accounting- Information for Decision Making

View Set