Corporate Finance - Chapter 13
Bankruptcy is very valuable because:
-Payments to creditors cease pending the outcome of the bankruptcy process. -It can be used strategically to improve a firm's competitive position.
According to MM Proposition I, the value of a firm is the same for debt financing as it is for equity financing because of which of the following?
-The asset to be financed is the same. -MM demonstrated that debt financing is neither better nor worse than equity financing.
Which of the following are generally true about the cost of equity and the cost of debt?
-The cost of debt increases with leverage. -The cost of equity may increase with leverage. -The cost of debt is generally lower than the cost of equity.
Which of the following will apply when a firm's debt levels are extremely high?
-The possibility of financial distress will become a chronic problem. -The benefits of debt financing may be more than offset by the costs of financial distress.
An optimal capital structure will
-minimize the cost of capital -maximize the value of the firm
Rank each of the following in order of priority of payment.
1.Bankruptcy administrative expenses 2.Wages, salaries, and commissions 3.Consumer claims 4.Payment to common shareholders
Based on MM Proposition I with corporate taxes, the optimal capital structure is ________.
100% debt
Kline Construction is an all-equity firm that has projected perpetual earnings before interest and taxes of $628,000. The current cost of equity is 17.6 percent and the tax rate is 35 percent. The company is in the process of issuing $4.3 million of 8.3 percent annual coupon bonds at par. What is the levered value of the firm?
3,824,318
Infinity Completion, Inc. currently has 50,000 shares of stock outstanding and no debt. The price per share is $23.75. The firm is considering borrowing funds at 6 percent interest and using the proceeds to repurchase 5,000 shares of stock. Ignore taxes. How much is the firm borrowing?
5,000 × $23.75 = $118,750
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.
Which costs of financial distress are easier to measure?
Direct costs
Which of the following are examples of firms which filed for bankruptcy for strategic reasons?
Dow Corning Texaco Johns Manville Continental Airlines
Which of the following industries tend to have a low leverage?
Drugs Computers
Which of the two types of costs of bankruptcy are more difficult to quantify?
Indirect costs
Which two of the following are broad types of costs of financial distress?
Indirect costs Direct costs
Which of the following assumptions is necessary for MM Proposition I to hold?
Individuals can borrow on their own at an interest rate equal to that of the firm.
Which of the following is true of the impact of financial leverage?
It magnifies gains and losses
The present value of the interest tax shield equals what?
TC x D
How does the level of debt affect the weighted average cost of capital (WACC)?
The WACC initially falls and then rises as debt increases.
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.
The costs of financial distress depend mostly on how easily the ownership of the firm's ________ can be transferred.
assets
The fact that failure to meet debt obligations can result in bankruptcy is ______.
bad for the firm
During bankruptcy, the ownership of the firm's assets is transferred from stockholders to ___.
bondholders
The equity risk that comes from the nature of a firm's operating activities is known as:
business risk
The cost of debt will begin to increase as the:
degree of leverage increases
According to M&M Proposition I, a firm's capital structure choices:
do not affect the value of the firm Reason: M&M Proposition I argues that the value of the firm is independent of the firm's capital structure.
The weighted average cost of capital rises at higher levels of debt owing to:
financial distress costs
An investor who buys the common stock of a levered firm is subject to more risk due to the addition of
financial risk
The equity risk that comes from the financial policy or capital structure decisions of the firm is known as:
financial risk
The tax deductibility of interest payments is?
good for the firm
Equity carries risk thus an investor should expect a _____ return than that on less risky debt.
higher
If the degree of leverage increases, the cost of debt will ______.
increases
Customers refusing to buy GM cars when the company filed for Chapter 11 for fear of not being able to get service for the cars in the future is an example of ______ costs of financial distress.
indirect
The static theory of capital structure assumes a firm:
is fixed in terms of its assets and operations.
The value of a levered firm will be greater than the value of an identical unlevered firm because the levered firm's taxes will be ______.
lower
The possibility of bankruptcy costs has a(n) ______ effect on the value of the firm.
negative
The value of a levered firm in MM Proposition I with corporate taxes equals the value of an all equity firm:
plus the tax rate times the value of debt
The expected return on equity is _____ to leverage.
positively related
Volatility or ______ increases for equity holders when leverage increases.
risk
The idea that a firm borrows to the point that the tax benefit of debt is exactly equal to the increased probability of financial distress is called the _________ theory of capital structure.
static
It is often in everyone's best interest to devise a "workout" strategy that avoids bankruptcy because:
the bankruptcy process can be long and expensive
MM Proposition II shows that ___.
the cost of equity rises with leverage
A beneficial rule to follow is to set the firm's capital structure so that ___.
the firm's value is maximized
M&M Proposition I with taxes states that:
the levered value of a firm exceeds the firm's unlevered value.
Which of the following industries tend to have a high leverage?
Airlines Cable television
Destruction Builders has 10,000 shares of stock outstanding and no debt. The new CFO is considering issuing $65,000 of debt and using the proceeds to retire 750 shares of stock. The coupon rate on the debt is 7.2 percent. What is the break-even level of earnings before interest and taxes between these two capital structure options?
EPSU = EPSLEBIT / 10,000 = [EBIT − ($65,000 × .072)] / (10,000 − 750)EBIT = $62,400
The optimal level of debt in the presence of corporate taxes and bankruptcy costs occurs at the point at which the present value of distress costs _____ the present value of the tax shield benefits.
Equal
Which one of the following is a direct bankruptcy cost?
Legal and accounting fees related to a bankruptcy proceeding
Which one of the following statements is correct regarding bankruptcies post-2005?
Section 363 speeds up the bankruptcy process via a bidding process.
Which of the following statements are true regarding the effect of financial leverage and the firm's operating earnings (EBIT)?
The rate of return on assets is unaffected by leverage.
True or false: According to the absolute priority rule, administrative expenses associated with the bankruptcy are paid first in the distribution of the proceeds of liquidation.
True
Delta Mowers has a debt-equity ratio of .6. Its WACC is 11.8 percent, and its cost of debt is 7.7 percent. There is no corporate tax. What is the firm's cost of equity capital?
WACC = .118 = (1 / 1.6)RE + (.6 / 1.6)(.077) = .1426, or 14.26 percent
Which one of the following conditions exists at the point where a firm maximizes its value?
WACC is minimized.
Bankruptcy costs may exceed the tax shield benefits of _____.
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
MM Proposition I does not work with corporate taxes because:
levered firms pay lower taxes than unlevered firms
The tax shield afforded by debt will be of the least use to firms with ______ .
losses carried forward negative EBT
Under MM Proposition II, a firm's WACC remains unchanged regardless of changes in its capital structure because as the % of debt increases _______________ .
the increase in the cost of both debt and equity is exactly offset by the increase in the % of lower cost debt.
The Static Theory of Capital Structure suggests employing debt to the point that its cost equals the cost of ____________________.
the increased probability of bankruptcy
The tax savings attained by a firm from the tax deductibility of interest expense is called
the interest tax shield
Under MM Proposition II with no taxes, the weighted average cost of capital is invariant to the debt level because:
the return on assets (RA) is unchanged
The value of a levered firm will be _____ than the value of an identical unlevered firm because the levered firm's taxes will be _____.
Blank 1: greater Blank 2: lower
Catapult Movers has determined that $98,000 is the break-even level of earnings before interest and taxes for the two capital structures it is considering. The one structure consists of all equity with 30,000 shares of stock. The second structure consists of 20,000 shares of stock and $400,000 of debt. What is the interest rate on the debt?
EPSU = EPSL$98,000 / 30,000 = [$98,000 − ($400,000 × r)] / 20,000r = 8.17 percent
True or false: The legal process of bankruptcy is typically quick and inexpensive.
False Reason: Bankruptcy is often a lengthy and expensive process.
True or false: Holding equity in an unlevered firm has no risk.
False Reason: Equity still carries risk thus an investor should expect a higher return than that on less risky debt.
True or false: Direct costs are very difficult to measure and, thus, are often estimated.
False Reason: Indirect costs are difficult to measure.
True or false: When total book liabilities exceed the book value of the total assets, a firm is said to have reached fallen angel insolvency.
False Reason: It has reached accounting insolvency when book liabilities exceed book value of total assets.
Which one of the following statements concerning financial leverage is correct?
Financial leverage magnifies both profits and losses.
How is the optimal debt level is determined?
In a subjective manner
Which of the following are direct costs of financial distress?
Legal fees Administrative expenses
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
Omnipotent, LLC is an all-equity firm with 75,000 shares of stock outstanding and a total market value of $984,000. Based on its current capital structure, the firm is expected to have earnings before interest and taxes of $226,560 if the economy is normal, $64,000 if the economy is in a recession, and $356,000 if the economy booms. Ignore taxes. Management is considering issuing $165,000 of debt at a coupon rate of 7.5 percent. If the firm issues the debt, the proceeds will be used to repurchase stock. What will the earnings per share be if the debt is issued and the economy is in a recession?
Shares repurchased $165,000 / ($984,000 / 75,000) = 12,576 sharesShares outstanding = 75,000 − 12,576 = 62,424 sharesEPSRecession = [$64,000 − ($165,000 × .075)] / 62,424 = $0.83
Which one of the following is an implication of M&M Proposition II without taxes?
The risk of equity is affected by both financial and operating leverage.
True or false: Firm value is maximized when the WACC is minimized.
True
True or false: It is possible for the present value of distress costs to exceed the present value of tax savings.
True
True or false: MM demonstrated that debt financing is neither better nor worse than equity financing.
True
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
Graceful Funeral Group expects its earnings before interest and taxes to be $325,000 a year forever. Currently, the firm has no debt. The cost of equity is 19.5 percent and the tax rate is 21 percent. The company is in the process of issuing $3.7 million of bonds at par that carry an annual coupon rate of 6.5 percent. What is the unlevered value of the firm?
Vu = [$287,600 × (1 − .34)] / .154 = $1,232,571Vu = [$325,000 × (1 − .21)] / .195 = $1,316,667
Glass Growers has a cost of capital of 11.1 percent. The company is considering converting to a debt-equity ratio of .46. The interest rate on debt is7.3 percent. What would be the company's new cost of equity? Ignore taxes.
WACC = .111 = (1 / 1.46)(RE) + (.46 / 1.46)(.073)RE = .1285, or 12.85 percent
What are some examples of indirect financial distress costs?
lost reputation lost sales
True or false: Based on MM Proposition I, even including taxes, capital structure does not matter to the firm.
False Reason: Once taxes are included, capital structure matters.
True or false: Stockholders care most about the dividend maximization of the firm.
False Reason: They care most about maximizing the overall value of the firm.
An individual can duplicate a levered firm through a strategy called ______ leverage where the investor uses his own funds plus borrowed funds to buy stocks.
homemade
With ______ ______, an investor is able to replicate a corporation's capital structure by borrowing funds and using those funds along with their own money to buy the company's stock.
homemade leverage
The cost of debt is generally _____ than the cost of equity.
lower
True or false: There is a precise mathematical equation for determining the optimal level of debt for any firm.
False Reason: The optimal debt level is determined in a subjective manner. There is no precise equation.
Last Minute Loan Services is an all-equity firm with a total market value of $1,221,350 and 50,000 shares of stock outstanding. Management is considering issuing $225,000 of debt at an interest rate of 6.25 percent and using the proceeds on a stock repurchase. Ignore taxes. How many shares will the firm repurchase if it issues the debt securities? (Round the number of shares repurchased down to the nearest whole share.)
Shares repurchased = $225,000 / ($1,221,350 / 50,000) = 9,211 shares
Financial distress can arise in the form of possible:
Legal bankruptcy Business failure
What is generally the most important component of direct bankruptcy costs?
Legal costs
Peter's Tools recently defaulted on a bank loan. To avoid a bankruptcy proceeding, the bank agreed to a composition. This composition would do which one of the following?
Reduce the amount of the loan payments so Peter's can pay on time
M&M Proposition I states if the assets and operations (left-hand side of the balance sheet) for two firms are the same, then ___________________ .
the value of the two firms is equal how the firms are financed is irrelevant
