CHAPTER 17 SMARTBOOK CORP FINANCE FINN3603

Which of the following are differences between interest payments and dividend payments by the corporation?

*dividend payments are not an obligation but interest payments are an obligation *dividends are paid to stockholders while interest is paid to bondholders *dividend income is not fixed while interest income is generally fixed

In a shareholder-bondholder relationship, the ______ is the principal.

BONDHOLDER

Firm value initially increases when the proportion of debt in the capital structure increases due to the ___.

DEBT TAX SHIELD

Who is more likely to indulge in wasteful behavior?

INC LEISURE TIME INC WORK RELATED PERQUISITES TAKE ON UNPROFITABLE PROJECTS

Protective covenants typically ______ interest rates.

LOWER

Who are the main claimants of a firm's cash flows?

STOCKHOLDERS BONDHOLDERS GOVERNMENT

Most non financial companies issue ______ debt.

TOO LITTLE

As debt is ______ the capital structure, the present value of financial distress costs ______.

ADDED TO; INCREASES

An example of an cost is when a firm issues more equity and an entrepreneur increases leisure time.

AGENCY

From a tax shield perspective, what is the expected relationship between a firm's profitability and its level of debt?

AS PROFITABILITY INCREASES, A FIRM WILL INCREASE THE LEVEL OF DEBT

When is the present value of distress costs likely to exceed the present value of the tax shield from debt?

AT HIGH LEVELS OF DEBT

Which of the following industries have high leverage ratios?

BUILDING CONSTRUCTION HOTEL/GAMING

Which of the following is true after an LBO?

COMPANY IS OWNED BY A FEW INVESTORS OWNERSHIP PATTERN CHANGES

Which of the following matter to capital structure?

CORPORATE AND PERSONAL TAX

The value of a firm is equal to the value of its:

DEBT PLUS EQUITY

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

DIRECT COSTS INDIRECT COSTS

In 2010, the U.S. collected over $400 billion in corporate taxes. What do these figures suggest about the capital structure choices of U.S. firms?

DO NOT USE ENOUGH DEBT TO CAPITALIZE ON TAX SHIELD

MM's assertion of a positive relationship between firm value and leverage is widely observed in the business world.

FALSE

True or false: Protective covenants are classified as either direct or indirect covenants.

FALSE

The payment to lawyers become relevant in the context of capital structure decisions in the event of ____.

FINANCIAL DISTRESS

The trade-off theory implies that there is an optimal level of debt, but the pecking-order theory suggests that each firm chooses its leverage ratio based on ____.

FINANCING NEEDS

In a leveraged buyout (LBO), current shareholders are bought out at a price that is ____.

HIGHER THAN MARKET PRICE

The value of a firm will ______ when the firm first uses leverage if we assume that there are no bankruptcy costs.

INCREASE

Volatility in income ______ the probability of financial distress.

INCREASES

What is the impact on the present value of distress costs as more debt is added?

INCREASES

In an agency relationship the:

PRINCIPAL DELEGATES DECISION MAKING AUTHORITY TO AN AGENT

A _________ covenant is an agreement between bondholders and stockholders

PROTECTIVE

The value of the firm is ______ by the agency costs of equity.

REDUCED

According to the pecking order theory, what is the preferred source for firms seeking to raise capital?

RETAINED EARNINGS

How does the concept of limited liability apply to shareholders?

SHAREHOLDERS CANNOT BE PERSONALLY LIABLE FOR THE DEBTS OF THE CORPORATION

What are shareholders liable for if the firm is in financial distress and can pay only 80% of the payment due to the bondholders?

SINCE SHAREHOLDERS ARE LIMITED LIABILITY, THEY ARE NOT PERSONALLY RESPONSIBLE FOR THE DEBT OBLIGATIONS OF THE FIRM

Highly profitable firms are likely to have higher debt ratios because they can deduct interest for _____ purposes.

TAX

Firms with volatile operating income tend to have lower debt ratios because ___.

THERE IS HIGHER PROBABILITY OF EXPERIENCING FINANCIAL DISTRESS

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

TRUE

Which of the following factors affect the establishment of a target debt-equity ratio?

TYPE OF ASSETS, TANGIBLE OR INTANGIBLE UNCERTAINTY OF OPERATING INCOME TAXES

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

VALUE OF FIRM INCREASES WITH LEVERAGE

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

VALUE OF FIRM= VALUE OF EQUITY + VALUE OF DEBT

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

From a tax shield perspective, why would a firm with low profits not borrow much?

B/C FIRM NEEDS ONLY A SMALL INTEREST DEDUCTION TO OFFSET PRETAX PROFITS

In a world with no financial distress where dividends and interest are taxed at the same personal rate, firms will prefer to issue ______.

DEBT

Should a firm issue debt or equity if both dividend income and interest income are taxed at the same rate? Assume there is no prospect of financial distress.

DEBT

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

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 - LOSS OF REPUTATION

What is generally the most important component of direct costs of financial distress?

LEGAL COSTS

Which type of firm is more susceptible to selfish shareholder strategies?

LEVERED FIRM FACING FINANCIAL DISTRESS

What are some examples of indirect financial distress costs?

LOST SALES LOST REPUTATION

Firms in which managers have ______ equity ownership tend to have ______ leverage.

LOW; HIGHER HIGH; LOWER

Bankruptcy costs are likely to be ______ if there are fewer groups of lenders.

LOWER

What are the benefits of having fewer lenders during bankruptcy?

MAKES IT EASIER FOR FIRM TO NEGOTIATE WITH LENDERS IT REDUCES THE CONFLICTS AMONG LENDERS

Who owns most of the firm after an LBO?

MANAGERS

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

What are the two types of protective covenants?

NEGATIVE POSITIVE

What is the upper limit on payments to bondholders by the corporation regardless of the level of profits?

OBLIGATION DUE IN TERMS OF INTEREST AND PRINCIPAL

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

PECKING ORDER THEORY

In order to understand the effect of taxes on capital structure decisions, we need to consider both corporate and ______ taxes.

PERSONAL

Modigliani and Miller suggest that there is a(n) ______ relationship between leverage and firm value in the presence of corporate taxes.

POSITIVE

What are the advantages of using internal financing?

PREVENTS ADVERSE MARKET REACTION THAT TENDS TO ACCOMPANY A STOCK ISSUE MAY BE CHEAPER THAN DEBT OR EQUITY ISSUES