HIGGINS CHAPTER 6

The evidence indicates that, on average, a company's stock price declines when it announces a new issue of equity.

true

When a company is in financial distress, its shareholders may have an incentive to undertake excessively risky investments.

true

The M&M irrelevance proposition assures financial managers that their choice between equity or debt financing will ultimately have no impact on firm value.

false

Debt financing results in lower after-tax earnings relative to equity financing.

true

If the maturity of a company's liabilities is less than that of its assets, the company incurs a refinancing risk.

true

In some instances, additional debt financing can encourage managers to act more in the interests of owners.

true

Salinas Corporation has net income of $15 million per year on net sales of $90 million per year. It currently has no long-term debt, but is considering a debt issue of $20 million. The interest rate on the debt would be 7%. Salinas Corp. currently faces an effective tax rate of 40%. What would be the annual interest tax shield to Salinas Corp. if it goes through with the debt issuance? A. $560,000 B. $1,400,000 C. $8,000,000 D. $20,000,000

A. $560,000 Interest tax shield = interest rate × amount of debt × tax rate = 0.07 × 20,000,000 × 0.40= $560,000

When considering the impact of distress costs on capital structure, which of the following facts should lead ABC Corporation to set a higher target debt ratio than XYZ Corporation (all else equal)? A. ABC's cash flows from operations are less volatile than XYZ's. B. ABC is a computer software firm, and XYZ is an electric utility. C. ABC operates in a more competitive industry than XYZ. D. ABC's assets have lower resale values than XYZ's assets.

A. ABC's cash flows from operations are less volatile than XYZ's.

Please refer to the financial information for Squamish Equipment above. For next year, calculate Squamish's times-burden-covered ratio if Squamish sells 2 million new shares at $20 a share. A. 1.03 B. 1.38 C. 1.60 D. 1.89 E. 2.10 F. None of the above.

E. 2.10

Which of the following would not be considered a cost of financial distress? Which of the following would not be considered a cost of financial distress? A. Lack of interest tax shields B. Bankruptcy costs C. Excessive risk-taking by shareholders D. Loss of customers or suppliers

A. Lack of interest tax shields

Under the simplifying assumptions of Modigliani and Miller, an increase in a firm's financial leverage will: A. increase the variability in earnings per share. B. reduce the operating risk of the firm. C. increase the value of the firm. D. decrease the value of the firm.

A. increase the variability in earnings per share.

Which of the following is NOT a likely financing policy for a rapidly growing business? A. Adopt a modest dividend payout policy that enables the company to finance most of its growth externally. B. Borrow funds rather than limit growth, thereby limiting growth only as a last resort. C. Maintain a conservative leverage ratio to ensure continuous access to financial markets. D. If external financing is necessary, use debt to the point it does not affect financial flexibility. E. None of the above.

B. Borrow funds rather than limit growth, thereby limiting growth only as a last resort.

Which of the following factors favor the issuance of debt in the financing decision? I. Market signaling II. Distress costs III. Management incentives IV. Financial flexibility A. I and II only B. I and III only C. II and IV only D. I, II, and III only E. I, II, and IV only F. None of the above.

B. I and III only

Which of the following factors favor the issuance of debt in the financing decision? I. Market signaling II. Distress costs III. Tax benefits IV. Financial flexibility A. I and II only B. I and III only C. II and IV only D. I, II, and III only E. I, II, and IV only F. None of the above.

B. I and III only

The basic lesson of the M&M theory is that the value of a firm is dependent upon: A. the firm's capital structure. B. the total cash flow of the firm. C. minimizing the marketed claims. D. the amount of marketed claims to that firm. E. the size of the stockholders' claims. F. None of the above.

B. the total cash flow of the firm.

Please refer to the financial information for Squamish Equipment above. For next year, calculate Squamish's earnings per share if Squamish sells 2 million new shares at $20 a share. A. 1.28 B. 1.39 C. 2.00 D. 2.22 E. 4.00 F. None of the above.

C. 2.00

Please refer to the financial information for Squamish Equipment above. Calculate Squamish's earnings per share next year assuming Squamish raises $40 million of new debt at an interest rate of 7 percent. A. 1.28 B. 2.00 C. 2.12 D. 2.22 E. 3.06 F. None of the above.

C. 2.12

Which of the following is/are helpful for evaluating the effect of leverage on a company's risk and potential returns? I. Estimated pro forma coverage ratios II. The recognition that financing decisions do not affect firm or shareholder value III. A range of earnings chart and proximity of expected EBIT to the breakeven value IV. A conservative debt policy that obviates the need to evaluate risk A. I only B. III only C. I and III only D. II and III only E. IV only F. None of the above.

C. I and III only

The interest tax shield has no value when a firm has: I. no taxable income. II. debt-equity ratio of 1. III. zero debt. IV. no leverage. A. I and III only B. II and IV only C. I, III, and IV only D. II, III, and IV only E. I, II, and IV only F. None of the above.

C. I, III, and IV only

Which of the following factors favor the issuance of equity in the financing decision? I. Market signaling II. Distress costs III. Management incentives IV. Financial flexibility A. I and II only B. I and III only C. II and IV only D. II, III, and IV only E. I, II, and IV only F. None of the above.

C. II and IV only

Which of the following is NOT an implication of the pecking order theory of capital structure? A. On average, a firm's stock price drops when it announces an equity issue. B. Firms may want to maintain a reserve of cash or unused borrowing capacity. C. More-profitable firms (all else equal) should have higher debt ratios. D. Firms may fail to undertake positive-NPV projects if they would have to be financed with a new issue of equity.

C. More-profitable firms (all else equal) should have higher debt ratios.

The best financing choice is the one that: A. sets the debt-to-assets ratio equal to 1. B. trades off the tax disadvantage of debt against the signaling effects of equity. C. maximizes expected cash flows. D. ignores the false comfort of financial flexibility. E. results in the lowest possible financial distress costs.

C. maximizes expected cash flows.

Homemade leverage is: A. the incurrence of debt by a corporation in order to pay dividends to shareholders. B. the exclusive use of debt to fund a corporate expansion project. C. the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage. D. best defined as an increase in a firm's debt-equity ratio. E. the term used to describe the capital structure of a levered firm. F. None of the above.

C. the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage.

Please refer to the financial information for Squamish Equipment above. Calculate Squamish's times-burden-covered ratio for the next year assuming the firm raises $40 million of new debt at an interest rate of 7 percent and that annual sinking fund payments on the new debt will equal $8 million. A. 1.01 B. 1.08 C. 1.38 D. 1.49 E. 1.95 F. None of the above.

D. 1.49

Please refer to the financial information for Squamish Equipment above. Calculate Squamish's times-interest-earned ratio for next year assuming the firm raises $40 million of new debt at an interest rate of 7 percent. A. 2.00 B. 3.09 C. 3.66 D. 4.35 E. None of the above.

D. 4.35

According to the pecking order theory of capital structure, why do firms avoid issuing equity? A. Because fees associated with issuing new equity are so high B. Because they want to avoid dilution of earnings per share C. Because they don't want to commit to paying dividends on the new equity D. Because equity issuance signals that managers believe their stock is overvalued, which causes the price of the stock to fall

D. Because equity issuance signals that managers believe their stock is overvalued, which causes the price of the stock to fall

The term "financial distress costs" includes which of the following? I. Direct bankruptcy costs II. Indirect bankruptcy costs III. Direct costs related to being financially distressed, but not bankrupt IV. Indirect costs related to being financially distressed, but not bankrupt A. I only B. III only C. I and II only D. III and IV only E. I, II, III, and IV F. None of the above.

E. I, II, III, and IV

According to the pecking order theory proposed by Stewart Myers of MIT, which of the following are correct? I. For financing needs, firms prefer to first tap internal sources such as retained profits and excess cash. II. There is an inverse relationship between a firm's profit level and its debt level. III. Firms prefer to issue new equity rather than source external debt. IV. A firm's capital structure is dictated by its need for external financing. A. I and III only B. II and IV only C. I, III, and IV only D. I, II, and IV only E. I, II, III, and IV F. None of the above.

D. I, II, and IV only

Financial leverage: I. increases expected ROE but does not affect its variability. II. increases breakeven sales, like operating leverage, but increases the rate of earnings per share growth once breakeven is achieved. III. is a fundamental financial variable affecting sustainable growth. IV. increases expected return and risk to owners. A. I and II only B. I and III only C. II and IV only D. II, III, and IV only E. I, II, III, and IV F. None of the above.

D. II, III, and IV only

Which of the following statements regarding interest tax shields is correct? A. Taxes are reduced by the amount of a firm's interest-bearing debt. B. Taxable income is reduced by the amount of a firm's interest-bearing debt. C. Taxes are reduced by the amount of the interest on a firm's debt. D. Taxable income is reduced by the amount of the interest on a firm's debt.

D. Taxable income is reduced by the amount of the interest on a firm's debt.

In general, the capital structures used by non-financial U.S. firms: A. typically result in debt-to-asset ratios between 60 and 80 percent. B. tend to converge to the same proportions of debt and equity. C. tend to be those that maximize the use of the firm's available tax shelters. D. vary significantly across industries. E. None of the above.

D. vary significantly across industries