Exam 15: Capital Structure: Limits to the Use of Debt

The TrunkLine Company will earn $60 in one year if it does well.The debtholders are promised payments of $35 in one year if the firm does well.If the firm does poorly,expected earnings in one year will be $30 and the repayment will be $20 because of the dead weight cost of bankruptcy.The probability of the firm performing poorly or well is 50%.If bondholders are fully aware of these costs what will they pay for the debt? The interest rate on the bonds is 10%.

Indirect costs of bankruptcy are born principally by:

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

The free cash flow hypothesis states:

A firm may file for Chapter 11 bankruptcy: I.in an attempt to gain a competitive advantage. II.using a prepack. III.while allowing the current management to continue running the firm. IV.even though it is not insolvent.

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: 50% Personal tax rate on income from stocks: 12%

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

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 $2,000 and will return $2,500 in one year.The discount rate for both bonds and stock is 15% and the tax rate is zero.The predicted cash flows without the project are $4,500 in a good economy,$3,000 in an average,economy and $1,000 in a poor economy.Each economic outcome is equally likely and the promised debt repayment is $3,000 with or without the project.Should the company take the project? What is the value of the firm and its debt and equity components before and after the project addition?