Question 1

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. 
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.

Question 2

The Aggie Company has EBIT of $70,000 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)  $355,938. 
A)  $120,000. 
B)  $162,948. 
C)  $258,537. 
D)  $263,080. 
E)  $355,938.

Question 3

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 4

One of the indirect costs to bankruptcy is the incentive toward underinvestment.Following this strategy may result in:

Accepted Answer

A)  the firm always choosing projects with the positive NPVs. 
B)  the firm accepting negative NPV projects that it would clearly reject in an all equity firm. 
C)  bondholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the benefits of the project. 
D)  both the firm always choosing projects with the positive NPVs; and stockholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the benefits of the project. 
E)  both the firm turning down positive NPV projects that it would clearly accept in an all equity firm; and stockholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the benefits of the project. 
A)  the firm always choosing projects with the positive NPVs. 
B)  the firm accepting negative NPV projects that it would clearly reject in an all equity firm. 
C)  bondholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the benefits of the project. 
D)  both the firm always choosing projects with the positive NPVs; and stockholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the benefits of the project. 
E)  both the firm turning down positive NPV projects that it would clearly accept in an all equity firm; and stockholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the benefits of the project.

Question 5

Your firm has a debt-equity ratio of .60.Your cost of equity is 11% and your after-tax cost of debt is 7%.What will your cost of equity be if the target capital structure becomes a 50/50 mix of debt and equity?

Accepted Answer

A)  9.50%. 
B)  10.50%. 
C)  11.00%. 
D)  11.25%. 
E)  12.00%. 
A)  9.50%. 
B)  10.50%. 
C)  11.00%. 
D)  11.25%. 
E)  12.00%.

Question 6

Given realistic estimates of the probability and cost of bankruptcy,the future costs of a possible bankruptcy are borne by:

Accepted Answer

A)  by all investors in the firm. 
B)  debtholders only because if default occurs interest and principal payments are not made. 
C)  equityholders because debtholders will pay less providing less cash for the equityholders. 
D)  management because if the firm defaults they will lose their jobs. 
A)  by all investors in the firm. 
B)  debtholders only because if default occurs interest and principal payments are not made. 
C)  equityholders because debtholders will pay less providing less cash for the equityholders. 
D)  management because if the firm defaults they will lose their jobs.

Question 7

Rotomax Inc.has recently undertaken a lot of new ventures and borrowed a huge sum of money from the market.Currently,its face value of debt face equals $150 (all figures are in millions).The firm's assets will be worth either $200 (boom)or $135 (recession)next year.Currently,it has a new project that will generate $60 next year with certainty.The investment needed for this project is $52.Assume that probability of each state is 0.50.
How much is this project opportunity worth? How much is the project opportunity worth to current equity holders if they have to finance the project by equity? Will the current shareholders be interested in investing in this project?

Accepted Answer

The project is worth $60 - $54 = $8.If e

Question 8

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 9

When graphing firm value against debt levels,the debt level that maximizes the value of the firm is the level where:

Accepted Answer

A)  the increase in the present value of distress costs from an additional dollar of debt is greater than the increase in the present value of the debt tax shield. 
B)  the increase in the present value of distress costs from an additional dollar of debt is equal to the increase in the present value of the debt tax shield. 
C)  the increase in the present value of distress costs from an additional dollar of debt is less than the increase of the present value of the debt tax shield. 
D)  distress costs as well as debt tax shields are zero. 
E)  distress costs as well as debt tax shields are maximized. 
A)  the increase in the present value of distress costs from an additional dollar of debt is greater than the increase in the present value of the debt tax shield. 
B)  the increase in the present value of distress costs from an additional dollar of debt is equal to the increase in the present value of the debt tax shield. 
C)  the increase in the present value of distress costs from an additional dollar of debt is less than the increase of the present value of the debt tax shield. 
D)  distress costs as well as debt tax shields are zero. 
E)  distress costs as well as debt tax shields are maximized.

Question 10

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 11

Given a situation where the corporate tax rate is 34%,and the personal tax rate on dividends is 28%,what must the personal tax rate on interest be to achieve the Miller equilibrium?

Accepted Answer

(1 - .34)(1 - .28)=

Question 12

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 13

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

Question 14

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

Accepted Answer

A)  finance with internally generated funds as there is no market interaction. 
B)  always issue debt then the market won't know when management thinks the security is overvalued. 
C)  reduce asymmetry before any financing activity. 
D)  increase the financial slack to reduce the reliance on internally generated funds. 
A)  finance with internally generated funds as there is no market interaction. 
B)  always issue debt then the market won't know when management thinks the security is overvalued. 
C)  reduce asymmetry before any financing activity. 
D)  increase the financial slack to reduce the reliance on internally generated funds.

Question 15

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

Accepted Answer

A)  rank all projects and take the project which results in the highest expected value of the firm. 
B)  rank all projects and take the project which results in the highest expected value of the firm's bonds. 
C)  rank all projects and take the project which results in the highest expected value of the firm's stock. 
D)  always take the low risk project. 
A)  rank all projects and take the project which results in the highest expected value of the firm. 
B)  rank all projects and take the project which results in the highest expected value of the firm's bonds. 
C)  rank all projects and take the project which results in the highest expected value of the firm's stock. 
D)  always take the low risk project.

Question 16

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)  the personal tax rate on interest income is zero. 
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)  the personal tax rate on interest income is zero.

Question 17

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

Accepted Answer

A)  significantly higher 
B)  slightly higher 
C)  equal 
D)  lower 
A)  significantly higher 
B)  slightly higher 
C)  equal 
D)  lower

Question 18

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 19

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

Accepted Answer

A)  causes the owners-managers to work less hard and shirk their duties as they have less capital at risk. 
B)  causes the owner-managers 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)  cause agency costs to fall as owner-managers do not need to worry about other shareholders. 
E)  cause the owner-manager to reduce shirking and perquisite consumption as the excess cashflow must be used to meet debt payments. 
A)  causes the owners-managers to work less hard and shirk their duties as they have less capital at risk. 
B)  causes the owner-managers 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)  cause agency costs to fall as owner-managers do not need to worry about other shareholders. 
E)  cause the owner-manager to reduce shirking and perquisite consumption as the excess cashflow must be used to meet debt payments.

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

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.

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

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

The Aggie Company has EBIT of $70,000 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.

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

One of the indirect costs to bankruptcy is the incentive toward underinvestment.Following this strategy may result in:

Your firm has a debt-equity ratio of .60.Your cost of equity is 11% and your after-tax cost of debt is 7%.What will your cost of equity be if the target capital structure becomes a 50/50 mix of debt and equity?

Given realistic estimates of the probability and cost of bankruptcy,the future costs of a possible bankruptcy are borne by:

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

When graphing firm value against debt levels,the debt level that maximizes the value of the firm is the level where:

Conflicts of interest between stockholders and bondholders are known as:

Given a situation where the corporate tax rate is 34%,and the personal tax rate on dividends is 28%,what must the personal tax rate on interest be to achieve the Miller equilibrium?

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:

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 ____.

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

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

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

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

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

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

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%

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

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 .