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

Assume the corporate tax rate is 22 percent,the personal tax rate on interest income is 15 percent,and the personal tax rate on dividends is 10 percent.Also assume the firm earns $5 per share in taxable income and pays out 40 percent of its earnings.How much will a shareholder receive per share in aftertax income?

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Question 1

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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 another type of risk?

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Question 2

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Some of the observed variations in capital structures across industries reflect the differences in the nature of the industries themselves,i.e.,business risk.Similarly,intuition would suggest that firms with large capital requirements and stable cash flows (e.g.,electric utilities)are more likely to be willing to raise funds via large amounts of borrowing (financial risk).Alternatively,firms with lower tangible asset needs and highly uncertain cash flows (e.g.,small software companies)are more likely to employ equity.Thus,firms with lower business risk may tend to accept higher levels of financial risk and vice versa.Thus,firms can and do trade off financial and business risks.

One of the indirect costs of bankruptcy is the effect that a potential bankruptcy has on the firm's decisions.The general result is that:

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Question 3

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In general,U.S.firms:

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Question 4

Assume BJ Companies is indifferent between issuing equity and issuing debt.Assume the corporate tax rate is 21 percent and dividends are taxed at the personal level at 20 percent.What is the personal tax on interest income?

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Question 5

The pecking order states that firms should:

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Question 6

Suppose a potential bondholder requires an indenture agreement to include a limit on dividend distributions by the bond's issuer and also a restriction on the sale of the issuer's assets.In this case,the bondholder is most likely concerned about:

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Question 7

Which one of the following statements is true?

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Question 8

The value of a firm is maximized when the:

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Question 9

Wigdor Manufacturing is currently all-equity financed,has an EBIT of $2 million and has a corporate tax rate of 21 percent.Louis,the company's founder,is the lone shareholder.All earnings are paid out as dividends to Louis.If the firm were to convert $4 million of equity into debt,the cost would be 10 percent and Louis would hold all the debt.Assume Louis pays personal taxes on interest income at a rate of 37 percent but pays taxes on dividends at a rate of 20 percent.Calculate the total cash flow to Louis after he pays personal taxes if the firm is unlevered and if it is levered.

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Question 10

TL Company has outstanding debt of $50 that is due in one year.However,given the financial distress costs,the debtholders will only receive $40 if the firm does well and $15 if it does poorly.The probability the firm will do well is 60 percent with the 40 percent probability assigned to poor conditions.What is the current value of the debt if the discount rate is 8 percent?

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Question 11

What is the estimated direct cost of financial distress as a percentage of the market value of a firm as estimated by White,Altman,and Weiss?

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Question 12

Which one of these best exemplifies "milking the property"?

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Question 13

Which one of these is most related to a positive covenant?

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Question 14

Mary owns 100 percent of a gift shop with an equity value of $150,000.If she keeps the shop open 5 days a week,EBIT is $75,000.If the shop remains open 6 days a week,EBIT increases to $92,000 annually.Mary needs an additional $50,000 which she can raise today by either selling stock or issuing debt at an interest rate of 7 percent.The principal amount would be repaid at the end of the fifth year.Ignore taxes.What will be the cash flow for this year to Mary if she issues debt,remains open 6 days a week,and distributes all the residual cash flow to the shareholders?

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Question 15

Of these five U.S.industries,which one tends to have the highest level of debt as a percentage of the market value of debt plus equity?

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Question 16

Wigdor Manufacturing is currently all-equity financed,has an EBIT of $2 million and has a corporate tax rate of 21 percent.Louis,the company's founder,is the lone shareholder.All earnings are paid out as dividends to Louis.If the firm were to convert $4 million of equity into debt at a cost of 10 percent,what would be the total cash flow from the firm to Louis if he holds all the debt? Compare this to Louis' total cash flow if the firm remains unlevered.

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Question 17

Shareholders sometimes pursue selfish strategies when financial distress is present.These actions generally result in:

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Question 18

Corporations in the U.S.,as compared to other countries,tend to:

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Question 19

Allison's requires $180,000 to fund a new project next year.The firm expects to earn excess cash of $68,000 this year after all expenses,taxes,and dividends are paid.The firm can borrow up to $150,000 at 6.5 percent interest for up to ten years or,it can issue up to 25,000 new shares of stock that will have an estimated value of $35 a share at the end of this year.According to the pecking-order theory,how much will the firm raise in new equity capital to fund this project?

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Question 20

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

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 another type of risk?

One of the indirect costs of bankruptcy is the effect that a potential bankruptcy has on the firm's decisions.The general result is that:

In general,U.S.firms:

Assume BJ Companies is indifferent between issuing equity and issuing debt.Assume the corporate tax rate is 21 percent and dividends are taxed at the personal level at 20 percent.What is the personal tax on interest income?

The pecking order states that firms should:

Suppose a potential bondholder requires an indenture agreement to include a limit on dividend distributions by the bond's issuer and also a restriction on the sale of the issuer's assets.In this case,the bondholder is most likely concerned about:

Which one of the following statements is true?

The value of a firm is maximized when the:

What is the estimated direct cost of financial distress as a percentage of the market value of a firm as estimated by White,Altman,and Weiss?

Which one of these best exemplifies "milking the property"?

Which one of these is most related to a positive covenant?

Of these five U.S.industries,which one tends to have the highest level of debt as a percentage of the market value of debt plus equity?

Shareholders sometimes pursue selfish strategies when financial distress is present.These actions generally result in:

Corporations in the U.S.,as compared to other countries,tend to:

Introduction to Corporate Finance

Financial Statements and Cash Flow

Financial Statements and Cash Flow

Discounted Cash Flow Valuation

Net Present Value and Other Investment Rules

Making Capital Investment Decisions

Risk Analysis, real Options, and Capital Budgeting

Interest Rates and Bond Valuation

Stock Valuation

Lessons From Market History

Return, risk, and the Capital Asset Pricing Model Capm

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

Risk, cost of Capital, and Valuation

Efficient Capital Markets and Behavioral Challenges

Long-Term Financing

Capital Structure: Basic Concepts

Valuation and Capital Budgeting for the Levered Firm

Dividends and Other Payouts

Raising Capital

Leasing

Options and Corporate Finance

Options and Corporate Finance: Extensions and Applications

Warrants and Convertibles

Derivatives and Hedging Risk

Short-Term Finance and Planning

Cash Management

Credit and Inventory Management

Mergers,acquisitions,and Divestitures

Financial Distress

International Corporate Finance

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