Question 1

The optimal capital structure will tend to include more debt for firms with:

Accepted Answer

A)  the highest depreciation deductions. 
B)  the lowest marginal tax rate. 
C)  substantial tax shields from other sources. 
D)  lower probability of financial distress. 
E)  less taxable income. 
A)  the highest depreciation deductions. 
B)  the lowest marginal tax rate. 
C)  substantial tax shields from other sources. 
D)  lower probability of financial distress. 
E)  less taxable income.

Question 2

Which of the following is true when a firm has level coupon debt outstanding and growth opportunities?

Accepted Answer

A)  The firm should be 100% debt financed because the greater the debt the greater tax shield. 
B)  100% debt financing is suboptimal because increased firm value does not increase the current interest needed to shield income today. 
C)  Firm value will only increase if the debt level is increased to 100%. 
D)  The high growth firm will have high debt ratios as they need greater financing. 
A)  The firm should be 100% debt financed because the greater the debt the greater tax shield. 
B)  100% debt financing is suboptimal because increased firm value does not increase the current interest needed to shield income today. 
C)  Firm value will only increase if the debt level is increased to 100%. 
D)  The high growth firm will have high debt ratios as they need greater financing.

Question 3

Conflicts of interest between stockholders and bondholders are known as:

Accepted Answer

A)  trustee costs. 
B)  financial distress costs. 
C)  dealer costs. 
D)  agency costs. 
E)  underwriting costs. 
A)  trustee costs. 
B)  financial distress costs. 
C)  dealer costs. 
D)  agency costs. 
E)  underwriting costs.

Question 4

The TrunkLine Company debtholders are promised payments of $35 if the firm does well, but will receive only $20 if the firm does poorly. If the bonds are selling at a price of $25, the promised return to the bondholders is approximately:

Accepted Answer

A)  2.90%. 
B)  40.00%. 
C)  27.30%. 
D)  16.86%. 
E)  100.00%. 
A)  2.90%. 
B)  40.00%. 
C)  27.30%. 
D)  16.86%. 
E)  100.00%.

Question 5

The Zercon Company has EBIT of $50,000 and market value debt of $100,000 outstanding with a 9% coupon rate. The cost of equity for an all equity firm would be 14%. Zercon has a 35% corporate tax rate. Investors face a 20% tax rate on debt receipts and a 15% rate on equity. Determine the value of Zercon.

Accepted Answer

A)  $263,080. 
B)  $332,143. 
C)  $258,537. 
D)  $162,948. 
E)  $120,000. 
A)  $263,080. 
B)  $332,143. 
C)  $258,537. 
D)  $162,948. 
E)  $120,000.

Question 6

The value of the firm is the sum of all claims against it. These marketed and non-marketed claims:

Accepted Answer

A)  increase in value together and are both bought and sold in the financial markets. 
B)  trade-off against one another in value with marketed claims bought and sold in the financial markets but not non-marketable claims. 
C)  decrease in value together and are both bought and sold in the financial markets. 
D)  trade-off against one another in value with both marketed and non-marketed claims bought and sold in the financial markets. 
A)  increase in value together and are both bought and sold in the financial markets. 
B)  trade-off against one another in value with marketed claims bought and sold in the financial markets but not non-marketable claims. 
C)  decrease in value together and are both bought and sold in the financial markets. 
D)  trade-off against one another in value with both marketed and non-marketed claims bought and sold in the financial markets.

Question 7

The value of a firm in financial distress is diminished if the firm:

Accepted Answer

A)  has no bankruptcy risk. 
B)  is declared solvent and does not undergo financial reorganization. 
C)  is a partnership. 
D)  both is declared bankrupt and proceeds to be liquidated; and is a partnership. 
E)  both is declared bankrupt and proceeds to be liquidated; and is declared insolvent and undergoes financial reorganization. 
A)  has no bankruptcy risk. 
B)  is declared solvent and does not undergo financial reorganization. 
C)  is a partnership. 
D)  both is declared bankrupt and proceeds to be liquidated; and is a partnership. 
E)  both is declared bankrupt and proceeds to be liquidated; and is declared insolvent and undergoes financial reorganization.

Question 8

Given the following information, leverage will add how much value to the unlevered firm per dollar of debt? Corporate tax rate: 30%
Personal tax rate on income from bonds: 20%
Personal tax rate on income from stocks: 0%

Accepted Answer

A)  $0.125. 
B)  $0.472. 
C)  $0.528. 
D)  $0.825. 
A)  $0.125. 
B)  $0.472. 
C)  $0.528. 
D)  $0.825.

Question 9

The All-Mine Corporation is deciding whether to invest in a new project. The project would have to be financed by equity, the cost is $2000 and will return $2500 or 25% in one year. The discount rate for both bonds and stock is 15% and the tax rate is zero. The predicted cashflows are $4500 in a good economy, $3000 in an average, economy and $1000 in a poor economy. Each economic outcome is equally likely and the promised debt repayment is $3000. Should the company take the project? What is the value of firm and its components before and after the project addition?

Accepted Answer

Determine cashflows before the project.

Question 10

The Lanoi Company has EBIT of $30,000 and market value debt of $150,000 outstanding with an 8% coupon rate. The cost of equity for an all equity firm would be 12%. Lanoi has a 30% corporate tax rate. Investors face a 20% tax rate on debt receipts and a 12% rate on equity. Determine the value of Lanoi.

Accepted Answer

A)  $130,500. 
B)  $142,698. 
C)  $248,537. 
D)  $209,500. 
E)  $332,143. 
A)  $130,500. 
B)  $142,698. 
C)  $248,537. 
D)  $209,500. 
E)  $332,143.

Question 11

Although the use of debt provides tax benefits to the firm, debt also puts pressure on the firms to:

Accepted Answer

A)  meet interest and principal payments which if not met can put the company into financial distress. 
B)  make dividend payments which if not met can put the company into financial distress. 
C)  meet both interest and dividend payments which when met increase the firm cash flow. 
D)  meet increased tax payments thereby increasing firm value. 
A)  meet interest and principal payments which if not met can put the company into financial distress. 
B)  make dividend payments which if not met can put the company into financial distress. 
C)  meet both interest and dividend payments which when met increase the firm cash flow. 
D)  meet increased tax payments thereby increasing firm value.

Question 12

TL Company has expected earnings of $75 in one year if it does well and $25 if it does poorly. The firm has outstanding debt of $50 that is due in one year. However, given the financial distress costs, the debtholders will only receive $40 in one year if the firm does well and $15 if it does poorly. There is a 60 percent chance the firm will do well and a 40 percent chance that it will do poorly. What is the current value of the debt if the interest rate on bonds is 8 percent?

Accepted Answer

A)  $27.78 
B)  $27.50 
C)  $30.00 
D)  $26.67 
E)  $28.40 
A)  $27.78 
B)  $27.50 
C)  $30.00 
D)  $26.67 
E)  $28.40

Question 13

The main difference between a positive and negative covenants is(are):

Accepted Answer

A)  a positive covenant is one you must not do while a negative covenant must be carried out. 
B)  actions that you must do regularly versus periodically. 
C)  a positive covenant is one you must do while a negative covenant is to limit actions the firm can take. 
D)  no difference as they are both restrictive. 
A)  a positive covenant is one you must not do while a negative covenant must be carried out. 
B)  actions that you must do regularly versus periodically. 
C)  a positive covenant is one you must do while a negative covenant is to limit actions the firm can take. 
D)  no difference as they are both restrictive.

Question 14

The free cash flow hypothesis states:

Accepted Answer

A)  that firms with greater free cash flow will pay more in dividends reducing the risk of financial distress. 
B)  that firms with greater free cash flow should issue new equity to force managers to minimize wasting resources and to work harder. 
C)  that issuing debt requires interest and principal payments reducing the potential of management to waste resources. 
D)  that issuing equity reduces the potential of management to waste resources. 
A)  that firms with greater free cash flow will pay more in dividends reducing the risk of financial distress. 
B)  that firms with greater free cash flow should issue new equity to force managers to minimize wasting resources and to work harder. 
C)  that issuing debt requires interest and principal payments reducing the potential of management to waste resources. 
D)  that issuing equity reduces the potential of management to waste resources.

Question 15

When shareholders pursue selfish strategies such as taking large risks or paying excessive dividends, these will result in:

Accepted Answer

A)  no action by debtholders since these are equity holder concerns. 
B)  positive agency costs, as bondholders impose various restrictions and covenants, which will diminish firm value. 
C)  investments of the same risk class that the firm is in. 
D)  undertaking scale enhancing projects. 
E)  lower agency costs, as shareholders have more control over the firm's assets. 
A)  no action by debtholders since these are equity holder concerns. 
B)  positive agency costs, as bondholders impose various restrictions and covenants, which will diminish firm value. 
C)  investments of the same risk class that the firm is in. 
D)  undertaking scale enhancing projects. 
E)  lower agency costs, as shareholders have more control over the firm's assets.

Question 16

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: 10%
Personal tax rate on income from stocks: 50%

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 17

The possibility of bankruptcy has a negative effect on the value of the firm because:

Accepted Answer

A)  increased bankruptcy risk lowers value. 
B)  reorganization is costless but risk is not. 
C)  a bankruptcy has real costs associated with it. 
D)  value enhancing strategies are no longer available. 
A)  increased bankruptcy risk lowers value. 
B)  reorganization is costless but risk is not. 
C)  a bankruptcy has real costs associated with it. 
D)  value enhancing strategies are no longer available.

Question 18

The MM theory with taxes implies that firms should issue maximum debt. In practice, this is not true because:

Accepted Answer

A)  debt is more risky than equity. 
B)  bankruptcy is a disadvantage to debt. 
C)  firms will incur large agency costs of short term debt by issuing long term debt. 
D)  both debt is more risky than equity; and bankruptcy is a disadvantage to debt. 
E)  both bankruptcy is a disadvantage to debt; and firms will incur large agency costs of short term debt by issuing long term debt. 
A)  debt is more risky than equity. 
B)  bankruptcy is a disadvantage to debt. 
C)  firms will incur large agency costs of short term debt by issuing long term debt. 
D)  both debt is more risky than equity; and bankruptcy is a disadvantage to debt. 
E)  both bankruptcy is a disadvantage to debt; and firms will incur large agency costs of short term debt by issuing long term debt.

Question 19

Describe some of the sources of business risk and financial risk. Do financial decision makers have the ability to "trade off" one type of risk for the other?

Accepted Answer

Students should intuitively recognize th

Question 20

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: 30%
Personal tax rate on income from stocks: 30%

Accepted Answer

A)  $0.246. 
B)  $0.340. 
C)  $0.006. 
D)  -$0.050. 
A)  $0.246. 
B)  $0.340. 
C)  $0.006. 
D)  -$0.050.

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

The optimal capital structure will tend to include more debt for firms with:

Which of the following is true when a firm has level coupon debt outstanding and growth opportunities?

Conflicts of interest between stockholders and bondholders are known as:

The TrunkLine Company debtholders are promised payments of $35 if the firm does well, but will receive only $20 if the firm does poorly. If the bonds are selling at a price of $25, the promised return to the bondholders is approximately:

The value of the firm is the sum of all claims against it. These marketed and non-marketed claims:

The value of a firm in financial distress is diminished if the firm:

Given the following information, leverage will add how much value to the unlevered firm per dollar of debt? Corporate tax rate: 30% Personal tax rate on income from bonds: 20% Personal tax rate on income from stocks: 0%

Although the use of debt provides tax benefits to the firm, debt also puts pressure on the firms to:

The main difference between a positive and negative covenants is(are):

The free cash flow hypothesis states:

When shareholders pursue selfish strategies such as taking large risks or paying excessive dividends, these will result in:

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: 10% Personal tax rate on income from stocks: 50%

The possibility of bankruptcy has a negative effect on the value of the firm because:

The MM theory with taxes implies that firms should issue maximum debt. In practice, this is not true because:

Describe some of the sources of business risk and financial risk. Do financial decision makers have the ability to "trade off" one type of risk for the other?

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: 30% Personal tax rate on income from stocks: 30%

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

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