Fin 125 Exam III

What does capital structure influence

- firm's risk profile - ease of receiving funding - cost of capital (how expensive that funding is) - return that investors and creditors expect - degree of insulation from both microeconomic business decisions and macroeconomic downturns

Value of a firm is determined by...

1) cash flows to the firm 2) risk of the assets

Two ways to maximize stockholders' wealth

1) maximize value of the firm 2) minimize the WACC

Case II assumptions

Corporate taxes, no personal taxes Bankruptcy costs

Case II assumptions

Corporate taxes, no personal taxes No bankruptcy costs

Break-even point of financial leverage

EBIT where ESP is the same under both the current and proposed capital structures

The concept of homemade leverage is most associated with: (A) M&M Proposition I with no tax. (B) M&M Proposition II with no tax. (C) M&M Proposition I with tax. (D) M&M Proposition II with tax. (E) the static theory proposition.

M&M Proposition I with no tax

Which one of the following states that the value of a company is unrelated to the company's capital structure? Homemade leverage M&M Proposition I, no tax M&M Proposition II, no tax Pecking-order theory Static theory of capital structure

M&M Proposition I, no tax

Case I assumptions

No corporate or personal taxes No bankruptcy costs

The present value of the interest tax shield is expressed as: Select one: TCD/RA. VU + TCD. TCDRA. [EBIT(TCD)]/RA. TCD. Correct

TcD

Static (Tradeoff) Theory

a firm borrows up to a point where tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress

M&M Theory Proposition II

a firm's cost of equity capital is a positive linear function of firm's capital structure

Value can change by...

changing the risk of cash flows or the cash flows themselves

Case II optimal capital structure

close to 100% debt as each additional dollar of debt increases the cash flow of the firm

You have computed the break-even point between a levered and an unlevered capital structure. Ignore taxes. At the break-even level, the: (A) company is earning just enough to pay for the cost of the debt. (B) company's earnings before interest and taxes are equal to zero. (C) earnings per share for the levered option are exactly double those of the unlevered option. (D) advantages of leverage exceed the disadvantages of leverage. (E) company has a debt-equity ratio of .50.

company is earning just enough to pay for the cost of the debt

The optimal capital structure has been achieved when the: (A) debt-equity ratio is equal to 1. (B) weight of equity is equal to the weight of debt. (C) cost of equity is maximized given a pretax cost of debt. (D) debt-equity ratio is such that the cost of debt exceeds the cost of equity. (E) debt-equity ratio results in the lowest possible weighted average cost of capital.

debt-equity ratio results in the lowest possible weighted average cost of capital

M&M Theory Proposition I

firm value is independent of the firm's capital structure

Pecking Order Theory

firms prefer to issue debt rather than equity if internal financing is insufficient

M&M Proposition II with taxes: Select one: has the same general implications as M&M Proposition II without taxes. states that capital structure is irrelevant to shareholders. supports the argument that business risk is determined by the capital structure decision. supports the argument that the cost of equity decreases as the debt-equity ratio increases. concludes that the capital structure decision is irrelevant to the value of a firm.

has the same general implications as M&M Proposition II without taxes

Which one of the following makes the capital structure of a company irrelevant? (A) Taxes (B) Interest tax shield (C) 100 percent dividend payout ratio (D) Debt-equity ratio that is greater than 0 but less than 1 (E) Homemade leverage

homemade leverage

The costs incurred by a business in an effort to avoid bankruptcy are classified as _____ costs. Select one: flotation direct bankruptcy indirect bankruptcy financial solvency capital structure

indirect bankruptcy

Westover Mills reduced its taxes last year by $210 by increasing its interest expense by $1,000. Which one of the following terms is used to describe this tax savings? Interest tax shield Interest credit Homemade leverage shield Current tax yield Tax-loss interest

interest tax shield

Which form of financing do companies prefer to use first according to the pecking-order theory? Select one: Regular debt Convertible debt Common stock Preferred stock Internal funds

internal funds

Rule 2 of Pecking order theory

issue debt next, new equity last

Increasing leverage

issuing new debt and using $ to buy back stock

Decreasing leverage

issuing new equity and using $ to pay off debt

If EBIT is > than break-even point...

leverage may be beneficial to stockholders

If EBIT < than break-even point...

leverage would be detrimental to shareholders

A firm should select the capital structure that: (A) produces the highest cost of capital. Incorrect (B) maximizes the value of the firm. (C) minimizes taxes. (D) is fully unlevered. (E) equates the value of debt with the value of equity.

maximizes the value of the firm

Case I optimal capital structure

no optimal capital strucutre

Case III optimal capital structure

part debt and part equity because the benefit from an additional dollar of debt is offset by the increase in expected bankruptcy costs

Financial risk

the additional return required by stockholders' to compensate for the risk of leverage

Which one of the following statements is correct in relation to M&M Proposition II, without taxes? (A) The cost of equity remains constant as the debt-equity ratio increases. (B) The cost of equity is inversely related to the debt-equity ratio. (C) The required return on assets is equal to the weighted average cost of capital. (D) Financial risk determines the return on assets. (E) Financial risk is unaffected by the debt-equity ratio.

the required return on assets is equal to the weighted average cost of capital

Business risk

the risk of a firm's assets

The basic lesson of M&M theory is that the value of a company is dependent upon: the total cash flows of that company.the company's capital structure. the total cash flows of that company. minimizing the marketed claims. the amount of the company's marketed claims. size of the stockholders' claims.

the total cash flows of that company

M&M Proposition I with taxes is based on the concept that: Select one: the optimal capital structure is the one that is totally financed with equity. capital structure is irrelevant because investors and companies have differing tax rates. WACC is unaffected by a change in the company's capital structure. the value of a taxable company increases as the level of debt increases. the cost of equity increases as the debt-equity ratio increases.

the value of a taxable company increases as the level of debt increases

What is the primary goal of financial managers?

to maximize stockholder wealth

Rule 1 of Pecking order theory

use internal financing first

If a company has the optimal amount of debt, then the: Select one: direct financial distress costs must equal the present value of the interest tax shield. value of the levered company will exceed the value of the unlevered company. company has no financial distress costs. Value of the firm is equal to VL + TCD. debt-equity ratio is equal to 1.

value of the levered company will exceed the value of the unlevered company

Capital restructuring

when a firm substitutes one capital structure for another while leaving the firm's assets unchanged