Chapter 16, FRL 301
M&M Proposition 2 is the proposition that:
A firms cost of equity is. alinear function with a slope equal to (Ra - RD)
M&M Proposition 1 with tax supports the theory that:
A firms weighted average cost of capital decreases as the firms debt equity ratio increases
The unleavened cost of capital refers to the cost of capital for a:
All equity firm
Which one of the following statements is correct concerning the relationship between a levered and an unlevered capital structure? Assume there are no taxes.
At the break even point there are non advantage to debt.
Which one of the following is the legal proceeding under which an insolvent firm can be reorganized?
Bankruptcy
Which one of the following statements related to Chapter 7 bankruptcy is correct?
Bankruptcy, a trustee will assume ontrol of the fims assets until those assets can be liquidated
Which one of the following is the equity risk that is most related to daily operations of a firm?
Business Risk
The optimal capital structure has been achieved when the:
Debt-equity ratio results in the lowest possible weighted average cost of capital
Based on M&M Proposition 2 with taxes, the weighted average cost of capital:
Decreases as the debt equity ration increases
The explicit costs, such as legal and administrative expenses, associated with corporate default are classified as _______ costs.
Direct bankruptcy
By definition, which of the following costs are included in the term "financial distress costs"?
Direct bankruptcy costs, Indirect bankruptcy costs, direct costs related to being financially distressed, but not bankrupt, & indirect costs related to being financially distressed, but not bankrupt.
The static theory of capital structure advocates that the optimal capital structure for a firm:
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 firms capital structure policy?
Financial
Which of the following statements related too financial risk are correct?
Financial risk is the risk associated with the use of debt financing, as financial risk increases so too does the cost of equity, Financial risk is wholly dependent upon the financial policy of a firm.
You have computed the break even point between a levered and an unlevered capital:
Firm is just earning enough to pay for the cost of the debt
Which one of the following are correct according to pecking order theory?
Firms stockpile internally generated cash, There is an inverse relationship between a firms profit level and its debt level, a firms capital structure is dictated by its need for external financing
The business Risk of a firm:
Has a positive relationship with the firms cost of equity
M&M Proposition 2 with taxes:
Has the same general implications as the M&M Proposition 2 without taxes.
Which one of the following makes the capital structure of a firm irrelevant?
Homemade leverage
Indirect Bankruptcy Costs
Impaired ability to conduct business
A firm may file for Chapter 11 bankruptcy:
In an attempt to gain a competitive advantage, using a prepack, while allowing the current management to continue running the firm.
The costs incurred by a business in an effort to avoid bankruptcy are classified as _______ costs.
Indirect bankruptcy
Butter and Jelly reduced its taxes last year by $350 by increasing its interest expenses by $1,000. Which of the following terms is used to describe this tax savings?
Interest tax shield
Which form of financing do firms prefer to use first according to the pecking order theory?
Internal funds
Break even EBIT
Is the EBIT that makes EPS the same under the current and proposed capital structure. When EBIT> the break even point, then the leverage benefits stockholders. When the EBIT < the break even point, then the leverage hurts the stockholders
A firm is technically insolvent when:
It is unable to meet its financial obligations
Direct Bankruptcy Costs
Legal and administrative costs
A business firm ceases to exist as a going concern as a result of which one of the following?
Liquidation
Which one of the following has the greatest tendency to increase the percentage of debt included in the optimal capital structure of a firm?
Low probabilities of financial distress
THE CONCEPT OF HOMEMADE LEVERAGE IS MOST ASSOCIATED WITH
M&M PROPOSITION 1 WITH NO TAX
Which one of the following states that the value of a firm is unrelated to the firms capital structure?
M&M Proposition 1
Which one of the following states that a firms cost of equity capital is directly and proportionally related to the firms capital structure?
M&M Proposition 2
A firm should select the capital structure that
Maximizes the value of the firm
The capital structure that maximizes the value of a firm also:
Minimizes the cost of capital
ROE
Net income| Equity
EPS
Net income| shares outstanding
Which one of the following id a direct bankruptcy cost
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?
Payment of employee wages
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005:
Permits key employee retention plans only if an employee has another job offer.
Financial Distress
Refers to significant problems in meeting debt obligations. Firms that experience financial distress do not necessarily file for bankruptcy. Financial Distress refers to the direct and indirect costs associated with going bankrupt or avoiding bankruptcy filings
Edwards Farm Products was unable to meets 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:
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.
Select the unlevered option since the expected EBIT is less than the break even level
Jessie invested in Quattro stock when the firm was unleavened. Since Quattro has changed its capital structure and now has a debt equity ratio of 3.0. to Unilever her position, Jessica needs to:
Sell some shares of Quattro stock and loan out the sale proceeds
The interest tax shield has no value when a firm has a
Tax rate of zero, zero debt, zero leverage
Present value of Interest Tax shield
Tax rate x Amount of debt tc x D
Annual Interest tax shield
Tax rate x Annual Interest payment Tc x DRd
The present value of the interpret tax shield is expressed as:
Tc x D
M&M Proposition 2
The Rd= cost of debt D|E is debt equity ratio Implications include: The cost of equity increases when leverage increases. The risk of equity depends on two things; 1. Business Risk or Ra, the riskiness of the firms operation and 2. Financial Risk, the degree of financial leverage.
Homemade leverage is:
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:
The debt equity ratio of a firm is completely irrelevant
The interest tax shield is a key reason why:
The net cost of debt to a firm is generally less than the cost of equity
Which of the following statements are correct in relation to M&M Proposition 2 with no taxes?tc X
The required return on assets is equal to the weighted average cost of capital and financial risk is determined by the debt equity ratio
The proposition that a firm borrows up to the point where the marginal benefit of the interest tax shield derived from its increased debt is just equal to the marginal expense of the resulting increase in financial distress costs is called:
The static theory of capital structure
The basic lesson of M&M theory is that the value of a firm is dependent upon:
The total cash flow of the firm
M&M Proposition 1 with taxes is based on the concept that:
The value of a firm increases as the firms debt increases because of the interest tax shield.
M&M Proposition 1
The value of the firm levered. That is levered has no effect on the firms value, A firms WACC is the same under any capital structure. Implications include: A firms capital structure is irrelevant, the leverage has no effect on the firms value. A firms WACC is the same under any capital structure.
Bankruptcy
Transfers value from shareholders to bondholders
Corporation in the U.S. tend to:
Underutilize debt
Capital structure and cost of Capital
Value of the firm is maximized when the wack is minimized
If a firm has the optimal amount of deb, then the:
Value of the levered firm will exceed the value of the firm if it were unlevered
In general, the capital structures used by U.S. firms
Vary significantly across industries
The value of a firm is maximized when the
Weighted average cost of capital is minimized
The absolute priority rule determines:
Which parties receive payment first Ina bankruptcy proceeding
The optimal capital structure
Will vary over time as taxes and market conditions change
Financial leverage
amplifies the variation in both EPS & ROE. A small change in leverage generates a large change in profits
Firm value and stock value
choose the capital structure that will maximize the value of the firm
