Question 1

What is the pecking order theory and what are the implications that arise from this theory?

Accepted Answer

The company will first use internal fina

Question 2

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 3

The Aggie 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%.Aggie 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 Aggie.

Accepted Answer

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

Question 4

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

Accepted Answer

A) the equityholders 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. 
E) None of the above. 
A) the equityholders 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. 
E) None of the above.

Question 5

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 6

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%.

Accepted Answer

A) $25.00 
B) $27.50 
C) $29.55 
D) $32.50 
E) $35.00 
A) $25.00 
B) $27.50 
C) $29.55 
D) $32.50 
E) $35.00

Question 7

An investment is available that pays a tax-free 6%.The corporate tax rate is 30%.Ignoring risk, what is the pre-tax return on taxable bonds?

Accepted Answer

A) 4.20% 
B) 6.00% 
C) 7.67% 
D) 8.57% 
E) None of the above. 
A) 4.20% 
B) 6.00% 
C) 7.67% 
D) 8.57% 
E) None of the above.

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 
E) None of the above 
A) $0.125 
B) $0.472 
C) $0.528 
D) $0.825 
E) None of the above

Question 9

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

Accepted Answer

A) the firm will rank all projects and take the project which results in the highest expected value of the firm. 
B) bondholders expropriate value from stockholders by selecting high risk projects. 
C) stockholders expropriate value from bondholders by selecting high risk projects. 
D) the firm will always take the low risk project. 
E) Both A and B. 
A) the firm will rank all projects and take the project which results in the highest expected value of the firm. 
B) bondholders expropriate value from stockholders by selecting high risk projects. 
C) stockholders expropriate value from bondholders by selecting high risk projects. 
D) the firm will always take the low risk project. 
E) Both A and B.

Question 10

Issuing debt instead of new equity in a closely held firm more likely:

Accepted Answer

A) causes the owner-manager to work less hard and shirk their duties as they have less capital at risk. 
B) causes the owner-manager to consume more perquisites because the cost is passed to the debtholders. 
C) causes both more shirking and perquisite consumption since the government provides a tax shield on debt. 
D) causes agency costs to fall as owner-managers do not need to worry about other shareholders. 
E) causes the owner-manager to reduce shirking and perquisite consumption as the excess cash flow must be used to meet debt payments. 
A) causes the owner-manager to work less hard and shirk their duties as they have less capital at risk. 
B) causes the owner-manager to consume more perquisites because the cost is passed to the debtholders. 
C) causes both more shirking and perquisite consumption since the government provides a tax shield on debt. 
D) causes agency costs to fall as owner-managers do not need to worry about other shareholders. 
E) causes the owner-manager to reduce shirking and perquisite consumption as the excess cash flow must be used to meet debt payments.

Question 11

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

Accepted Answer

A) is declared bankrupt and proceeds to be liquidated. 
B) is declared insolvent and undergoes financial reorganization. 
C) is a partnership. 
D) Both A and C. 
E) Both A and B. 
A) is declared bankrupt and proceeds to be liquidated. 
B) is declared insolvent and undergoes financial reorganization. 
C) is a partnership. 
D) Both A and C. 
E) Both A and B.

Question 12

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) Both A and C. 
E) Both B and C. 
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) Both A and C. 
E) Both B and C.

Question 13

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: 20%
Personal tax rate on income from stocks: 30%

Accepted Answer

A) $-0.050 
B) $0.006 
C) $0.246 
D) $0.340 
E) $0.423 
A) $-0.050 
B) $0.006 
C) $0.246 
D) $0.340 
E) $0.423

Question 14

Establishing a capital structure for a firm is not simple.Although financial theory guides the process, there is no simple formula.List and explain four main items that one should consider in determining the capital structure.

Accepted Answer

Some points to consider are:
o Taxes--ta

Question 15

Which of the following is not empirically true when formulating capital structure policy?

Accepted Answer

A) Some firms use no debt. 
B) Most corporations have low debt-asset ratios. 
C) There are no differences in the capital-structure of different industries. 
D) Debt levels across industries vary widely. 
E) Debt ratios in most countries are considerably less than 100%. 
A) Some firms use no debt. 
B) Most corporations have low debt-asset ratios. 
C) There are no differences in the capital-structure of different industries. 
D) Debt levels across industries vary widely. 
E) Debt ratios in most countries are considerably less than 100%.

Question 16

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 17

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

Question 18

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) $-0.050 
B) $0.006 
C) $0.246 
D) $0.340 
E) $0.660 
A) $-0.050 
B) $0.006 
C) $0.246 
D) $0.340 
E) $0.660

Question 19

What three factors are important to consider in determining a target debt to equity ratio?

Accepted Answer

A) Taxes, asset types, and pecking order and financial slack 
B) Asset types, uncertainty of operating income, and pecking order and financial slack 
C) Taxes, financial slack and pecking order, and uncertainty of operating income 
D) Taxes, asset types, and uncertainty of operating income 
E) None of the above. 
A) Taxes, asset types, and pecking order and financial slack 
B) Asset types, uncertainty of operating income, and pecking order and financial slack 
C) Taxes, financial slack and pecking order, and uncertainty of operating income 
D) Taxes, asset types, and uncertainty of operating income 
E) None of the above.

Question 20

In a Miller equilibrium, what type of investments do high tax bracket investors tend to hold?

Accepted Answer

A) Bonds 
B) Stocks 
C) Debentures 
D) Both stocks and bonds. 
E) Neither stocks nor bonds. 
A) Bonds 
B) Stocks 
C) Debentures 
D) Both stocks and bonds. 
E) Neither stocks nor bonds.

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

What is the pecking order theory and what are the implications that arise from this theory?

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

The Aggie 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%.Aggie 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 Aggie.

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

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

An investment is available that pays a tax-free 6%.The corporate tax rate is 30%.Ignoring risk, what is the pre-tax return on taxable bonds?

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%

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

Issuing debt instead of new equity in a closely held firm more likely:

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

The free cash flow hypothesis states:

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: 20% Personal tax rate on income from stocks: 30%

Establishing a capital structure for a firm is not simple.Although financial theory guides the process, there is no simple formula.List and explain four main items that one should consider in determining the capital structure.

Which of the following is not empirically true when formulating capital structure policy?

In Miller's model, when the quantity [(1 - Tc)(1 - Ts) = (1 - Tb)], 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 _____.

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%

What three factors are important to consider in determining a target debt to equity ratio?

In a Miller equilibrium, what type of investments do high tax bracket investors tend to hold?

Introduction to Corporate Finance

Financial Statements and Cash Flow

Financial Statements Analysis and Long-Term Planning

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

Risk and Return: Lessons From Market History

Return and Risk: the Capital Asset Pricing Model

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

Risk, Cost of Capital, and Capital Budgeting

Efficient Capital Markets and Behavioral Challenges

Long-Term Financing: an Introduction

Capital Structure: Basic Concepts

Valuation and Capital Budgeting for the Levered Firm

Dividends and Other Payouts

Issuing Securities to the Public

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 and Acquisitions

Financial Distress

International Corporate Finance

Filters

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 ___.