Chapter 18 MC Questions

When financial distress is a possibility, the value of a levered firm consists of: I) value of the firm if all-equity-financed; II) present value of tax shield; III) present value of costs of financial distress; IV) present value of omitted dividend payments

I + II - III

If a corporation cannot use its interest payments as a tax shield for a particular year because it has suffered a loss, it is still possible to use the tax shield because: I) the carry-back provision allows corporations to carry back the loss and receive a tax refund up to the amount of taxes paid in the previous two years; II) the carry-forward provision allows corporations to carry forward the loss and use it to shield income in subsequent years

I and II

MM Proposition I with corporate taxes states that: I) capital structure can affect firm value by an amount that is equal to the present value of the interest tax shield; II) by raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total value; III) firm value is maximized by using an all-equity capital structure

I and II

The costs of financial distress depend on the I) probability of financial distress; II) corporate and personal tax rates; III) magnitude of costs encountered if financial distress occurs

I and III only

Although the use of debt provides tax benefits to the firm, debt also puts pressure on the firm to: I) Meet interest and principal payments, which if not met can put the company into financial distress; II) make dividend payments, which if not met can put the company into financial distress; III) meet both interest and dividend payments, which when met increase the firm cash flow; IV) meet increased tax payments, thereby increasing firm value

I only

Given corporate taxes, why does adding debt to the capital structure increase firm value? I) Extra cash flow goes to the firm's investors rather than the tax authorities. II) Earnings before interest and taxes are fully taxed at the corporate rate. III) Personal tax rates are the same as marginal corporate tax rates.

I only

Financial slack includes: I) cash; II) marketable securities; III) readily salable real assets; IV) ready access to debt markets or bank loans

I, II, III, and IV

According to Rajan and Zingales, debt ratios of individual companies depend on: I) size: large firms have higher debt ratios; II) tangible assets: firms with high ratios of fixed assets to total assets have higher debt ratios; III) profitability: more profitable firms have lower debt ratios IV) market to book: firms with higher ratios of market-to-book value have lower debt ratios V) market structure: firms with monopoly power have higher debt ratios

I, II, III, and IV only

When faced with financial distress, managers of firms acting on behalf of their shareholders' interests will tend to: I) favor high-risk, high-return projects even if they have negative NPV; II) refuse to invest in low-risk, low-return projects with positive NPVs; III) delay the onset of bankruptcy as long as they can

I, II, and III

When faced with financial distress, managers of firms acting on behalf of their shareholders' interests will tend to: I) issue large quantities of low-quality debt versus low quantities of high-quality debt II) favor paying high dividends to shareholders III) delay the onset of bankruptcy as long as they can

I, II, and III

One of the indirect costs to bankruptcy is the incentive toward underinvestment. Following this strategy may result in: I) the firm always choosing projects with positive NPVs; II) stockholders turning down low-risk, low-return but positive NPV projects; III) the firm declaring and paying high cash dividends

II and III only

The pecking order theory of capital structure implies that: I) high-risk firms will end up borrowing more; II) firms prefer internal finance; III) firms prefer debt to equity when external financing is required

II and III only

Which of the following statements regarding financial distress is (are) true? I) Firms in financial distress always end up in bankruptcy. II) Firms can postpone bankruptcy for many years. III) Ultimately, the firm may recover from financial distress and avoid bankruptcy altogether.

II and III only

Why does MM Proposition I not hold in the presence of corporate taxes?

Levered firms pay lower taxes when compared with identical unlevered firms.

T/F When the costs of financial distress are included, the value of a levered firm is given by: Value of levered firm = value of unlevered firm + PV (tax shield) - PV (costs of financial distress).

True

Inclusion of restrictions in a bond contract leads to:

higher agency costs.

Compared to a firm with unlimited liability, the limited liability feature of common equity results in a:

higher value to equityholders.

In order to calculate the tax shields provided by debt, the tax rate used is the:

marginal corporate tax rate.

What does "risk shifting" imply?

When faced with bankruptcy, managers tend to invest in high-risk, high-return projects.

In Miller's model, when the quantity (1 - TC)(1 - TpE) = (1 - Tp), then:

the tax shield on debt is exactly offset by higher personal taxes paid on interest income.

T/F According to the trade-off theory, more profitable firms should have more debt and thus higher debt ratios on average.

True

T/F Financial distress occurs when promises to creditors are not honored or honored with great difficulty.

True

T/F MM's Proposition I corrected for corporate taxes states that: Value of levered firm = value of unlevered firm + PV tax shield.

True

T/F Risk shifting, refusing to contribute equity, and playing for time, are some of the consequences of firms facing bankruptcy.

True

T/F The pecking order theory implies that firms prefer internal to external financing.

True

T/F The right to default is valuable to shareholders.

True

T/F The value of a levered firm, given permanent debt level D, is: Value of levered firm = value of unlevered firm + (TC) × (D). This assumes zero costs of financial distress.

True

T/F When (1 - Tp) = (1 - TpE)(1 - Tc), the impact of corporate and personal taxes makes the debt policy decision less significant.

True

For every dollar of operating income paid out as equity income, the shareholder realizes:

(1 - TpE) (1 - TC)

The pecking order theory of capital structure predicts that:

- if two firms are equally profitable, the more rapidly growing firm will borrow more, other things equal. - implies firms prefer internal to external financing - firms prefer debt to equity when external financing is required

According to the trade-off theory of capital structure:

- optimal capital structure occurs when the present value of tax savings on account of additional borrowing just offsets the increase in the present value of costs of distress. -predicts that safe firms should borrow more than risk ones

T/F The present value of the interest tax shield is the same regardless of whether the firm plans to borrow permanently or temporarily.

False

Which of the following is NOT a potential result from financial distress?

Due to interest tax shields, the firm's effective tax rate is very low.

T/F Always use the average corporate tax rate to calculate the interest tax shields for firms.

False

T/F Financial distress always results in bankruptcy.

False

T/F The existence of personal taxes on interest income and equity income will always increase the advantage of debt to a firm.

False

T/F The existing tax code encourages a preference for equity over debt in corporate financing.

False

The MM theory with taxes implies that firms should issue maximum debt. In practice, this is not true because: I) debt is more risky than equity; II) bankruptcy and its attendant costs are a disadvantage to debt; III) the payment of personal taxes may offset the tax benefit of debt

II and III only Note: The possibility of significant bankruptcy costs and personal tax disadvantage of debt investing are just two factors that the mm theory with corporate taxes ignores. There are other factors (e.g., agency costs) that may be associated with debt financing. It is difficult to know exactly the net effect of these factors (and therefore difficult to know exactly how to determine the firm's optimal capital structure if there is one) but the good news is that the consequences of not being at the firmÕs opitmal capital structure are likely to be small compared to the consequences of making poor investment decisions. So you should generally focus your limited time on making good investment decisions (i.e., where you will put the firm's money) rather than making optimal financing decisions (i.e., where you get the money).

The main advantage of debt financing for a firm is: I) no SEC registration is required for bond issues; II) interest expenses are tax deductible; III) unlevered firms have higher value than levered firms

II only

When shareholders pursue strategies such as taking excessive risks or paying excessive dividends, these will result in: I) no action by debtholders since these are equityholder concerns; II) positive agency costs, as bondholders act on various restrictions and covenants, which will diminish firm value; III) investments of the same risk class that the firm is in

II only

In order to calculate the tax shield of interest payments for a corporation, always use the: I) average corporate tax rate II) marginal corporate tax rate; III) marginal rate on personal income tax

II) marginal corporate tax rate;

What are some of the possible consequences of financial distress? I) Bondholders, who face the prospect of getting only part of their money back, will likely want the company to take additional risks. II) Equity investors would like the company to cut its dividend payments to conserve cash. III) Equity investors would like the firm to shift toward riskier lines of business.

III only

Under the trade-off theory, how will a government loan guarantee impact financing?

Prefer to issue debt

What signal is sent to the market when a firm decides to issue new stock to raise capital?

Stock price is too high.

T/F A firm nearing bankruptcy has an incentive to issue more high risk debt.

True

Which of the following entities likely has the highest cost of financial distress?

The more tangible the assets available to liquidate, the lower the cost to exercise bankruptcy. A pharmaceuticals development company

In order to find the present value of the tax shields provided by debt, the discount rate used is the:

cost of debt

The indirect costs of bankruptcy are borne principally by:

stockholders

Assuming that bonds are sold at a fair price, the benefits from the interest tax shield go to the:

stockholders of the firm.