Question 1

Define and describe the direct and indirect costs of bankruptcy.Give three examples of each.

Accepted Answer

Direct Costs
- Legal and Administrative

Question 2

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 is such that the cost of debt exceeds the cost of equity. 
E) 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 is such that the cost of debt exceeds the cost of equity. 
E) debt-equity ratio selected results in the lowest possible weighed average cost of capital.

Question 3

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.

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.Bondholders are willing to pay $25.The promised return to the bondholders is approximately:

Accepted Answer

A) 2.9% 
B) 16.9% 
C) 27.3% 
D) 40.0% 
E) 100% 
A) 2.9% 
B) 16.9% 
C) 27.3% 
D) 40.0% 
E) 100%

Question 5

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) tend to increase as the debt-equity ratio decreases. 
E) 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) tend to increase as the debt-equity ratio decreases. 
E) include the costs incurred by a firm as it tries to avoid seeking bankruptcy protection.

Question 6

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

Question 7

The costs of avoiding a bankruptcy filing by a financially distressed firm are classified as _____ costs.

Accepted Answer

A) flotation 
B) direct bankruptcy 
C) indirect bankruptcy 
D) financial solvency 
E) capital structure 
A) flotation 
B) direct bankruptcy 
C) indirect bankruptcy 
D) financial solvency 
E) capital structure

Question 8

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

Accepted Answer

A) significantly higher 
B) slightly higher 
C) equal 
D) lower 
E) Either A or B 
A) significantly higher 
B) slightly higher 
C) equal 
D) lower 
E) Either A or B

Question 9

Although the use of debt provides tax benefits to the firm, debt also puts pressure on the firm 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. 
E) None of the above. 
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. 
E) None of the above.

Question 10

Suppose a Miller equilibrium exists with a corporate tax rate of 30% and a personal tax rate on income from bonds of 35%.What is the personal tax rate on income from stocks?

Accepted Answer

A) 0.0% 
B) 7.1% 
C) 10.05% 
D) 45.5% 
E) None of the above 
A) 0.0% 
B) 7.1% 
C) 10.05% 
D) 45.5% 
E) None of the above

Question 11

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) personal tax rate on interest income is zero. 
E) None of the above. 
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) personal tax rate on interest income is zero. 
E) None of the above.

Question 12

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: 50%

Accepted Answer

A) $-0.050 
B) $-0.188 
C) $0.367 
D) $0.588 
E) None of the above 
A) $-0.050 
B) $-0.188 
C) $0.367 
D) $0.588 
E) None of the above

Question 13

In a world with taxes and financial distress, when a firm is operating with the optimal capital structure:
I.the debt-equity ratio will also be optimal.
II.the weighted average cost of capital will be at its minimal point.
III.the required return on assets will be at its maximum point.
IV.the increased benefit from additional debt is equal to the increased bankruptcy costs of that debt.

Accepted Answer

A) I and IV only 
B) II and III only 
C) I and II only 
D) II, III, and IV only 
E) I, II, and IV only 
A) I and IV only 
B) II and III only 
C) I and II only 
D) II, III, and IV only 
E) I, II, and IV only

Question 14

What are the advantages of a prepackaged bankruptcy for a firm? What are the disadvantages?

Accepted Answer

A prepack allows a firm to minimize its

Question 15

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: 0%

Accepted Answer

A) $0.175 
B) $0.472 
C) $0.528 
D) $0.825 
E) None of the above 
A) $0.175 
B) $0.472 
C) $0.528 
D) $0.825 
E) None of the above

Question 16

Growth opportunities _______ the _____ of debt financing.

Accepted Answer

A) increase; advantage 
B) decrease; advantage 
C) decrease; disadvantage 
D) Both A and C 
E) None of the above 
A) increase; advantage 
B) decrease; advantage 
C) decrease; disadvantage 
D) Both A and C 
E) None of the above

Question 17

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) $-0.050 
B) $-0.188 
C) $0.188 
D) $0.633 
E) None of the above 
A) $-0.050 
B) $-0.188 
C) $0.188 
D) $0.633 
E) None of the above

Question 18

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 or 25% in one year.The discount rate for both bonds and stock is 15% and the tax rate is zero.The predicted cash flows 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.Should the company take the project? What is the value of firm and its components before and after the project addition?

Accepted Answer

Determine cash flows before the project.

Question 19

An exchange may offer:

Accepted Answer

A) allow customers a 30 day money-back guarantee on the firm's product. 
B) allow customers a 90 day warranty on the firm's product from defects. 
C) allow bondholders to exchange some debt for stock. 
D) allow stockholders to exchange some of their stock for debt. 
E) Both C and D. 
A) allow customers a 30 day money-back guarantee on the firm's product. 
B) allow customers a 90 day warranty on the firm's product from defects. 
C) allow bondholders to exchange some debt for stock. 
D) allow stockholders to exchange some of their stock for debt. 
E) Both C and D.

Question 20

The pecking order states how financing should be raised.In order to avoid asymmetric information problems and misinterpretation of whether management is sending a signal on security overvaluation, the firm's first rule is to:

Accepted Answer

A) finance with internally generated funds. 
B) always issue debt then the market won't know when management thinks the security is overvalued. 
C) issue new equity first. 
D) issue debt first. 
E) None of the above. 
A) finance with internally generated funds. 
B) always issue debt then the market won't know when management thinks the security is overvalued. 
C) issue new equity first. 
D) issue debt first. 
E) None of the above.

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

Define and describe the direct and indirect costs of bankruptcy.Give three examples of each.

The optimal capital structure has been achieved when the:

Indirect costs of bankruptcy are born principally by:

The TrunkLine Company debtholders are promised payments of $35 if the firm does well, but will receive only $20 if the firm does poorly.Bondholders are willing to pay $25.The promised return to the bondholders is approximately:

Indirect costs of financial distress:

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

The costs of avoiding a bankruptcy filing by a financially distressed firm are classified as _____ costs.

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

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

Suppose a Miller equilibrium exists with a corporate tax rate of 30% and a personal tax rate on income from bonds of 35%.What is the personal tax rate on income from stocks?

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

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: 50%

What are the advantages of a prepackaged bankruptcy for a firm? What are the disadvantages?

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: 0%

Growth opportunities _______ the _____ of debt financing.

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%

An exchange may offer:

The pecking order states how financing should be raised.In order to avoid asymmetric information problems and misinterpretation of whether management is sending a signal on security overvaluation, the firm's first rule is to:

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

Growth opportunities ___ the _ of debt financing.