Question 1

The optimal capital structure has been achieved when the:

Accepted Answer

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 pre-tax cost of debt. 
D)  debt-equity ratio selected results in the lowest possible weighed average cost of capital. 
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 pre-tax cost of debt. 
D)  debt-equity ratio selected results in the lowest possible weighed average cost of capital. D

Question 2

Junk bonds is a term used to describe bonds:

Accepted Answer

A)  of highest quality. 
B)  issued by junk yards. 
C)  with short periods to maturity. 
D)  with low yields to maturity. 
E)  with relatively higher probabilities of default. 
A)  of highest quality. 
B)  issued by junk yards. 
C)  with short periods to maturity. 
D)  with low yields to maturity. 
E)  with relatively higher probabilities of default. E

Question 3

While difficult to determine exactly, Lawrence A. Weiss estimated the distress costs to be about ____________ of firm value.

Accepted Answer

A)  1%. 
B)  3.1%. 
C)  5-6%. 
D)  8-10%. 
A)  1%. 
B)  3.1%. 
C)  5-6%. 
D)  8-10%. B

Question 4

Is there an easily identifiable debt-equity ratio that will maximize the value of a firm? Why or why not?

Accepted Answer

Students should explain that in a world

Question 5

The introduction of personal taxes may reveal a disadvantage to the use of debt if the:

Accepted Answer

A)  personal tax rate on the distribution of income to stockholders is less than the personal tax rate on interest income. 
B)  personal tax rate on the distribution of income to stockholders is greater than the personal tax rate on interest income. 
C)  personal tax rate on the distribution of income to stockholders is equal to the personal tax rate on interest income. 
D)  the personal tax rate on interest income is zero. 
A)  personal tax rate on the distribution of income to stockholders is less than the personal tax rate on interest income. 
B)  personal tax rate on the distribution of income to stockholders is greater than the personal tax rate on interest income. 
C)  personal tax rate on the distribution of income to stockholders is equal to the personal tax rate on interest income. 
D)  the personal tax rate on interest income is zero.

Question 6

In Miller's model, when the quantity (1-Tc)(1-Ts) = (1-Tb), then:

Accepted Answer

A)  the firm should hold no debt. 
B)  the value of the levered firm is greater than the value of the unlevered firm. 
C)  the tax shield on debt is exactly offset by higher personal taxes paid on interest income. 
D)  the tax shield on debt is exactly offset by higher levels of dividends. 
E)  the tax shield on debt is exactly offset by higher capital gains. 
A)  the firm should hold no debt. 
B)  the value of the levered firm is greater than the value of the unlevered firm. 
C)  the tax shield on debt is exactly offset by higher personal taxes paid on interest income. 
D)  the tax shield on debt is exactly offset by higher levels of dividends. 
E)  the tax shield on debt is exactly offset by higher capital gains.

Question 7

The basic lesson of MM theory is that the value of a firm is dependent upon the:

Accepted Answer

A)  capital structure of the firm. 
B)  total cash flows of the firm. 
C)  percentage of a firm to which the bondholders have a claim. 
D)  tax claim placed on the firm by the government. 
E)  size of the stockholders claims on the firm. 
A)  capital structure of the firm. 
B)  total cash flows of the firm. 
C)  percentage of a firm to which the bondholders have a claim. 
D)  tax claim placed on the firm by the government. 
E)  size of the stockholders claims on the firm.

Question 8

The optimal capital structure:

Accepted Answer

A)  will be the same for all firms in the same industry. 
B)  will remain constant over time unless the firm makes an acquisition. 
C)  of a firm will vary over time as taxes and market conditions change. 
D)  places more emphasis on the operations of a firm rather than the financing of a firm. 
E)  is unaffected by changes in the financial markets. 
A)  will be the same for all firms in the same industry. 
B)  will remain constant over time unless the firm makes an acquisition. 
C)  of a firm will vary over time as taxes and market conditions change. 
D)  places more emphasis on the operations of a firm rather than the financing of a firm. 
E)  is unaffected by changes in the financial markets.

Question 9

Covenants restricting the use of leasing and additional borrowings primarily protect:

Accepted Answer

A)  the equity holders from added risk of default. 
B)  the debtholders from the added risk of dilution of their claims. 
C)  the debtholders from the transfer of assets. 
D)  the management from having to pay agency costs. 
A)  the equity holders from added risk of default. 
B)  the debtholders from the added risk of dilution of their claims. 
C)  the debtholders from the transfer of assets. 
D)  the management from having to pay agency costs.

Question 10

The Do-All-Right Marketing Research firm has promised payments to their bondholders that total $100. The company believes that there is a 85% chance that the cash flow will be sufficient to meet these claims. However, there is a 15% chance that cash flows will fall short, in which case total earnings are expected to be $65. If the bonds sell in the market for $84, what is an estimate of the bankruptcy costs for Do-All-Right? Assume a cost of debt of 10%.

Accepted Answer

The expected amount bondholders receive

Question 11

Rotomax Inc. has recently undertaken a lot of new ventures and borrowed a huge sum of money from the market. Currently, its face value of debt face equals $150 (all figures are in millions). The firm's assets will be worth either $200 (boom) or $135 (recession) next year. Currently, it has a new project that will generate $60 next year with certainty. The investment needed for this project is $52. Assume that probability of each state is 0.50.
How much is this project opportunity worth? How much is the project opportunity worth to current equity holders if they have to finance the project by equity? Will the current shareholders be interested in investing in this project?

Accepted Answer

The project is worth $60 - $54 = $8. If

Question 12

Indirect costs of financial distress:

Accepted Answer

A)  effectively limit the amount of equity a firm issues. 
B)  serve as an incentive to increase the financial leverage of a firm. 
C)  include direct costs such as legal and accounting fees. 
D)  include the costs incurred by a firm as it tries to avoid seeking bankruptcy protection. 
A)  effectively limit the amount of equity a firm issues. 
B)  serve as an incentive to increase the financial leverage of a firm. 
C)  include direct costs such as legal and accounting fees. 
D)  include the costs incurred by a firm as it tries to avoid seeking bankruptcy protection.

Question 13

When firms issue more debt, the tax shield on debt ____, the agency costs on debt (i.e., costs of financial distress) ____, and the agency costs on equity ____.

Accepted Answer

A)  increases; increases; increases 
B)  decreases; decreases; decreases 
C)  increases; increases; decreases 
D)  decreases; decreases; increases 
E)  increases; decreases; decreases 
A)  increases; increases; increases 
B)  decreases; decreases; decreases 
C)  increases; increases; decreases 
D)  decreases; decreases; increases 
E)  increases; decreases; decreases

Question 14

Given the following information, leverage will add how much value to the unlevered firm per dollar of debt? Corporate tax rate: 34%
Personal tax rate on income from bonds: 50%
Personal tax rate on income from stocks: 10%

Accepted Answer

A)  -$0.188. 
B)  $0.340. 
C)  $0.633. 
D)  -$0.050. 
A)  -$0.188. 
B)  $0.340. 
C)  $0.633. 
D)  -$0.050.

Question 15

One of the indirect costs of bankruptcy is the incentive for managers to take large risks. When following this strategy, the firm will:

Accepted Answer

A)  rank all projects and take the project which results in the highest expected value of the firm. 
B)  rank all projects and take the project which results in the highest expected value of the firm's bonds. 
C)  rank all projects and take the project which results in the highest expected value of the firm's stock. 
D)  always take the low risk project. 
A)  rank all projects and take the project which results in the highest expected value of the firm. 
B)  rank all projects and take the project which results in the highest expected value of the firm's bonds. 
C)  rank all projects and take the project which results in the highest expected value of the firm's stock. 
D)  always take the low risk project.

Question 16

The optimal capital structure of a firm _____ the marketed claims and _____ the nonmarketed claims against the cash flows of the firm.

Accepted Answer

A)  minimizes; minimizes 
B)  minimizes; maximizes 
C)  maximizes; minimizes 
D)  maximizes; maximizes 
A)  minimizes; minimizes 
B)  minimizes; maximizes 
C)  maximizes; minimizes 
D)  maximizes; maximizes

Question 17

Given a situation where the corporate tax rate is 34%, and the personal tax rate on dividends is 28%, what must the personal tax rate on interest be to achieve the Miller equilibrium?

Accepted Answer

(1 - .34) (1 - .28)

Question 18

If the firm issues debt but writes protective and restrictive covenants into the loan contract, then the debt may be issued at a(an) _____ interest rate compared with otherwise similar debt.

Accepted Answer

A)  significantly higher 
B)  slightly higher 
C)  equal 
D)  lower 
A)  significantly higher 
B)  slightly higher 
C)  equal 
D)  lower

Question 19

Your firm has a debt-equity ratio of.60. Your cost of equity is 11% and your after-tax cost of debt is 7%. What will your cost of equity be if the target capital structure becomes a 50/50 mix of debt and equity?

Accepted Answer

A)  9.50%. 
B)  10.50%. 
C)  11.00%. 
D)  11.25%. 
E)  12.00%. 
A)  9.50%. 
B)  10.50%. 
C)  11.00%. 
D)  11.25%. 
E)  12.00%.

Question 20

Indirect costs of bankruptcy are born principally by:

Accepted Answer

A)  bondholders. 
B)  stockholders. 
C)  managers. 
D)  the Federal government. 
E)  the firm's suppliers. 
A)  bondholders. 
B)  stockholders. 
C)  managers. 
D)  the Federal government. 
E)  the firm's suppliers.

Exam 17: Capital Structure: Limits to the Use of Debt

The optimal capital structure has been achieved when the:

Junk bonds is a term used to describe bonds:

While difficult to determine exactly, Lawrence A. Weiss estimated the distress costs to be about ____________ of firm value.

Is there an easily identifiable debt-equity ratio that will maximize the value of a firm? Why or why not?

The introduction of personal taxes may reveal a disadvantage to the use of debt if the:

In Miller's model, when the quantity (1-Tc)(1-Ts) = (1-Tb), then:

The basic lesson of MM theory is that the value of a firm is dependent upon the:

The optimal capital structure:

Covenants restricting the use of leasing and additional borrowings primarily protect:

Indirect costs of financial distress:

When firms issue more debt, the tax shield on debt ____, the agency costs on debt (i.e., costs of financial distress) ____, and the agency costs on equity ____.

Given the following information, leverage will add how much value to the unlevered firm per dollar of debt? Corporate tax rate: 34% Personal tax rate on income from bonds: 50% Personal tax rate on income from stocks: 10%

One of the indirect costs of bankruptcy is the incentive for managers to take large risks. When following this strategy, the firm will:

The optimal capital structure of a firm _____ the marketed claims and _____ the nonmarketed claims against the cash flows of the firm.

Given a situation where the corporate tax rate is 34%, and the personal tax rate on dividends is 28%, what must the personal tax rate on interest be to achieve the Miller equilibrium?

If the firm issues debt but writes protective and restrictive covenants into the loan contract, then the debt may be issued at a(an) _____ interest rate compared with otherwise similar debt.

Your firm has a debt-equity ratio of.60. Your cost of equity is 11% and your after-tax cost of debt is 7%. What will your cost of equity be if the target capital structure becomes a 50/50 mix of debt and equity?

Indirect costs of bankruptcy are born principally by:

Introduction to Corporate Finance

Accounting Statements and Cash Flow

Financial Planning and Growth

Financial Markets and Net Present Value: First Principles of Finance

The Time Value of Money

How to Value Bonds and Stocks

Net Present Value and Other Investment Rules

Net Present Value and Capital Budgeting

Risk Analysis, Real Options, and Capital Budgeting

Risk and Return: Lessons From Market History

Risk and Return: the Capital Asset Pricing Model

An Alternative View of Risk and Return: the Arbitrage Pricing Theory

Risk, Return, and Capital Budgeting

Corporate Financing Decisions and Efficient Capital Markets

Long-Term Financing: an Introduction

Capital Structure: Basic Concepts

Valuation and Capital Budgeting for the Levered Firm

Dividends and Other Payouts

Issuing Equity Securities to the Public

Long-Term Debt

Leasing

Options and Corporate Finance: Basic Concepts

Options and Corporate Finance: Extensions and Applications

Warrants and Convertibles

Derivatives and Hedging Risk

Short-Term Finance and Planning

Cash Management

Credit Management

Mergers and Acquisitions

Financial Distress

International Corporate Finance

Filters

In Miller's model, when the quantity (1-T_c)(1-T_s) = (1-T_b), then:

When firms issue more debt, the tax shield on debt , the agency costs on debt (i.e., costs of financial distress) , and the agency costs on equity .

The optimal capital structure of a firm _ the marketed claims and _ the nonmarketed claims against the cash flows of the firm.