Deck 18: How Much Should a Corporation Borrow

Question 1

For every dollar of operating income paid out as interest, the bondholder realizes:

A) (1 - Tp)
B) (1 - TpE) (1 - TC)
C) (1 - TC)
D) None of the above

Answer 1

(1 - Tp)

Question 2

Assume the corporate tax rate is 30%. The firm has no debt in its capital structure. It is valued at $100 million. What would be the value of the firm if it issued $50 in perpetual debt and repurchased the equity?

A) $65
B) $115
C) $100
D) None of the above

Answer 2

$115

Question 3

MM's Proposition I corrected for the inclusion of corporate income taxes is expressed as:

A) VL = VU
B) VL = VU + D(1 - TC)
C) VL = VU + (TC)(D)
D) VU = VL + (TC)(D)

Answer 3

VL = VU + (TC)(D)

Question 4

MM Proposition I with corporate taxes states that:
I. Capital structure can affect firm value by an amount that is equal to the present value of the interest tax shield
II. By raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total value
III. Firm value is maximized at an all debt capital structure

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

Question 5

If a corporation cannot use its interest payments to get tax shield for a particular year because it has suffered a loss, it is still possible to get the tax shield because of the:
I. carry back provision that allows corporations to carry back the loss and receive a tax refund up to the amount of taxes paid in the previous two years.
II. carry forward provision that allows corporations to carry forward the loss and use it to shield income in subsequent years.

A) I only
B) II only
C) I and II
D) none of the above

Question 6

Assuming that bonds are sold at a fair price, the benefits from the tax shield go to the:

A) managers of the firm
B) bondholders of the firm
C) stockholders of the firm
D) lawyers of the firm

Question 7

In order to calculate the tax shields provided by debt, the tax rate used is the:

A) average corporate tax rate
B) marginal corporate tax rate
C) average of shareholders' tax rates
D) average of bondholders' tax rates

Question 8

In order to calculate the tax shield effect of interest payment for a corporation, always use the:
I. average corporate tax rate
II. marginal corporate tax rate
III. state mandated tax rate

A) I only
B) II only
C) III only
D) I and III only

Question 9

Suppose that a company can direct $1 to either debt interest or capital gains for equity investors. If there were no personal taxes on capital gains, which of the following investors would not care how the money was channeled? (The corporate tax rate is 35%)

A) Investors paying personal tax of 17.5%
B) Investors paying personal tax of 35%
C) Investors paying personal tax of 53%
D) None of the above

Question 10

Bombay Company's balance sheet is as follows:
(NWC = net working capital; LTA = long term assets; D = debt; E = equity; V = firm value):
According to MM's Proposition I corrected for taxes, what will be the change in company value if Bombay issues $200 of equity and uses it to make a permanent reduction in the company's debt? Assume a 35% tax rate.

A) +$140
B) +$70
C) $0
D) -$70

Question 11

The main advantage of debt financing for a firm is:
I. no SEC registration is required for bond issue
II. interest expense of a firm is tax deductible
III. unlevered firms have higher value than levered firms

A) I only
B) II only
C) III only
D) I and III only

Question 12

The reason that MM Proposition I does not hold good in the presence of corporate taxes is because:

A) Levered firms pay lower taxes when compared with identical unlevered firms
B) Bondholders require higher rates of return compared with stockholders
C) Earnings per share are no longer relevant with taxes
D) Dividends are no longer relevant with taxes

Question 13

If a firm borrows $50 million for one year at an interest rate of 10%, what is the present value of the interest tax shield? Assume a 30% tax rate. (Approximately.)

A) $1.364 million
B) $1.5 million
C) $1.0 million
D) $4.545 million
E) None of the above

Question 14

The positive value to the firm by adding debt to the capital structure in the presence of corporate taxes is:
I. Due to the extra cash flow going to the investors of the firm rather than the tax authorities
II. Due to the earnings before interest and taxes being fully taxed at the corporate rate
III. Because personal-tax rates are the same as corporate tax rates

A) I only
B) II only
C) III only
D) II and III only

Question 15

If a firm permanently borrows $100 million at an interest rate of 8%, what is the present value of the interest tax shield? (Assume that the tax rate is 30%)

A) $8.00 million
B) $5.6 million
C) $30 million
D) $26.67 million
E) None of the above

Question 16

For every dollar of operating income paid out as equity income, the shareholder realizes:

A) (1 - Tp)
B) (1 - TpE) (1 - TC)
C) (1 - TC)
D) None of the above

Question 17

If a firm borrows $50 million for one year at an interest rate of 9%, what is the present value of the interest tax shield? Assume a 30% tax rate.

A) $50.00 million
B) $17.50 million
C) $1.445 million
D) $1.239 million

Question 18

The relative tax advantage of debt with personal and corporate taxes is: Where: TC = (Corporate tax rate) = 35%; TpE = Personal tax rate on equity income = 30%; and Tp = Personal tax rate on interest income = 20%: (approximately)

A) 1.76
B) 1.16
C) 1.35
D) None of the given ones

Question 19

In order to find the present value of the tax shields provided by debt, the discount rate used is the:

A) cost of capital
B) cost of equity
C) cost of debt
D) none of the above

Question 20

If a firm permanently borrows $50 million at an interest rate of 10%, what is the present value of the interest tax shield? Assume a 30% tax rate.

A) $50.0 million
B) $25.0 million
C) $15.0 million
D) $1.5 million

Question 21

The value of the firm in the presence of debt may risk financial distress. Bankruptcy, the most severe type of financial distress, has an impact on value by:
I. the risk or probability that it may occur
II. the level of risk aversion investors have to debt
III. the total value of the firm being siphoned off to cover bankruptcy costs

A) I only
B) I and II only
C) III only
D) II only

Question 22

Which of the following statement(s) about financial distress is(are) true:
I. always ends in bankruptcy
II. firms can postpone bankruptcy for many years
III. ultimately the firm may recover and avoid bankruptcy altogether

A) I only
B) II only
C) II and III only
D) III only

Question 23

What are some of the possible consequences of financial distress?
I. Bondholders, who face the prospect of getting only part of their money back, are likely to want the company to take additional risks.
II. Equity investors would like the company to cut its dividend payments to conserve cash.
III. Equity investors would like the firm to shift toward riskier lines of business.

A) I only
B) II only
C) III only
D) I and II only

Question 24

Corporate tax rate: 34% Personal tax rate on income from bonds: 40% Personal tax rate on income from stocks: 30%

A) $0.246
B) $0.340
C) $0.006
D) $0.23

Question 25

In Miller's model, when the quantity (1 - TC)(1 - TpE) = (1 - Tp), then:

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) None of the above

Question 26

According to the trade-off theory of capital structure:

A) optimal capital structure is reached when the present value of tax savings on account of additional borrowing is just offset by increases in the present value of costs of distress.
B) optimal capital structure is reached when stockholders' right to default is balanced by the the bondholders' right to get interest and principal payments.
C) optimal capital structure is reached when the benefits of limited liability is just offset by the value of the lawyers' claim.
D) none of the above

Question 27

The MM theory with taxes implies that firms should issue maximum debt. In practice, this is not true because:
I. Debt is more risky than equity
II. Bankruptcy and its attendant costs is a disadvantage to debt
III. The payment of personal taxes may offset the tax benefit of debt

A) I only
B) II only
C) III only
D) II and III only

Question 28

The costs of financial distress depend on the:
I. probability of financial distress
II. corporate and personal tax rates
III. the magnitude of costs encountered if financial distress occurs

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

Question 29

Risk shifting implies:

A) When faced with bankruptcy, managers tend to invest in high risk, high return projects
B) When faced with bankruptcy, managers do not invest more equity capital
C) When faced with bankruptcy; managers may make accounting changes to conceal the true extent of the problem
D) All of the above

Question 30

One of the indirect costs to bankruptcy is the incentive toward under investment. Following this strategy may result in:
I. the firm always choosing projects with the positive NPVs
II. stockholders turning down low risk low return but positive NPV projects
III. stockholders would declare and receive high cash dividends

A) I only
B) II only
C) III only
D) II and III only

Question 31

When faced with financial distress; managers of firms acting on behalf of their shareholders' interests will:

A) favor issuing large quantity of low quality debt to low quantity of high quality debt
B) favor paying high dividends to the shareholders
C) delay the onset of bankruptcy as long as they can
D) all of the above

Question 32

Although the use of debt provides tax benefits to the firm, debt also puts pressure on the firm to:
I. Meet interest and principal payments which if not met can put the company into financial distress
II. Make dividend payments which if not met can put the company into financial distress
III. Meet both interest and dividend payments which when met increase the firm cash flow
IV. Meet increased tax payments thereby increasing firm value

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

Question 33

Suppose that a company can direct $1 to either debt interest or capital gains for equity investors. If half of equity income were subject to personal tax (e.g.: half is taxable dividends and half is tax-free capital gains) which investor would not care how the money is channeled? (The corporate tax rate is 35%)

A) Investors paying zero personal tax
B) Investors paying a personal tax rate of 53%
C) Investors paying a personal tax rate of 17.5%
D) None of the above

Question 34

In Miller's model, when Personal tax rate on income from bonds is equal to the personal tax rate on income from stocks:

A) relative advantage of debt depends only on the corporate tax rate
B) relative advantage of debt depends only on the personal tax rate on interest income
C) relative advantage of debt depends only on the personal tax rate on income from equity
D) none of the above

Question 35

When financial distress is a possibility, the value of a levered firm consists of:
I. value of the firm if all-equity-financed
II. present value of tax shield
III. present value of costs of financial distress
IV. present value of omitted dividend payments

A) I only
B) I + II
C) I + II - III
D) I + II - III - IV

Question 36

Indirect costs of bankruptcy are borne principally by:

A) Bondholders
B) Stockholders
C) Managers
D) The federal government

Question 37

(Approximately) Corporate tax rate: 34% Personal tax rate on income from bonds: 30% Personal tax rate on income from stocks: 20%

A) $0.66
B) $0.25
C) -$0.66
D) -$0.34

Question 38

When faced with financial distress; managers of firms acting on behalf of their shareholders' interests will:

A) favor high risk, high return projects even if they have negative NPV
B) refuse to invest in low risk, low return projects with positive NPVs
C) delay the onset of bankruptcy as long as they can
D) all of the above

Question 39

Corporate tax rate: 34% Personal tax rate on income from bonds: 10% Personal tax rate on income from stocks: 50%

A) -$0.188
B) $0.340
C) $0.633
D) None of the above

Question 40

When shareholders pursue selfish strategies such as taking large risks or paying excessive dividends, these will result in:
I. no action by debtholders since these are equity holder concerns
II. positive agency costs, as bondholders impose various restrictions and covenants, which will diminish firm value
III. investments of the same risk class that the firm is in

A) I only
B) II only
C) III only
D) I and III only

Question 41

The pecking order theory of capital structure predicts that:

A) If two firms are equally profitable, the more rapidly growing firm will borrow more, other things equal
B) Firms prefer equity to debt financing
C) Risky firms will end up borrowing less
D) Risky firms will end up borrowing more

Question 42

Under the trade off theory, how will a government loan guarantee impact financing?

A) Prefer to issue debt
B) Prefer to issue stock
C) Prefer internal money
D) No impact

Question 43

Inclusion of restrictions in the bond contract leads to:

A) Higher agency costs
B) Higher bankruptcy costs
C) Higher interest costs
D) None the above

Question 44

Personal taxes on interest income and equity income will always increase the advantage of debt to a firm.

Question 45

The pecking order theory of capital structure implies that:
I. Risky firms will end up borrowing more
II. Firms prefer internal finance
III. Firms prefer debt to equity when external financing is required

A) I only
B) II only
C) II and III only
D) III only

Question 46

Financial distress always results in bankruptcy.

Question 47

The right to default is valuable for the stockholders of firms.

Question 48

The value of a levered firm is given by:
Value of levered firm = Value (all equity financed) + (TC) * (D) This assumes that the debt is perpetual debt.

Question 49

MM's Proposition I corrected for corporate taxes states that: Value of levered firm = Value (all equity financed) + PV tax shield.

Question 50

The trade-off theory of capital structure predicts that:

A) Unprofitable firms should borrow more than profitable ones
B) Safe firms should borrow more than risky ones
C) Rapidly growing firms should borrow more than mature firms
D) Increasing leverage increases firm value

Question 51

Financial slack includes:
I. Cash
II. Marketable securities
III. Readily salable real assets
IV. Ready access to debt markets or bank loans

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

Question 52

According to Rajan and Zingales study, debt ratios of individual companies depend on:
I. Size: Large firms have higher debt ratios.
II. Tangible assets: Firms with high ratios of fixed assets to total assets have higher debt ratios.
III. Profitability: More profitable firms have lower debt ratios.
IV. Market to book: Firms with higher ratios of market-to-book value have lower debt ratios. V) Market structure: Firms with monopoly power have higher debt ratios.

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

Question 53

Financial distress occurs when promises to creditors are not honored or honored with great difficulty.

Question 54

What signal is sent to the market when a firm decides to issue new stock to raise capital?

A) Bond markets are overpriced
B) Bond markets are underpriced
C) Stock price is too low
D) Stock price is too high

Question 55

When cost of financial distress is included, the value of a levered firm is given by: Value of levered firm = Value (all equity financed) + PV (tax shield) - PV (costs of financial distress).

Question 56

Risk shifting, refusing to contribute equity and playing for time are some of the consequences of firms facing bankruptcy.

Question 57

According to the trade-off theory, more profitable firms should have more debt and thus the highest debt ratios.

Question 58

The present value of the interest tax shield is the same regardless of whether the firm plans to borrow permanently or temporarily.

Question 59

When (1 - Tp) = (1 - TpE)(1 - TC), corporate and personal taxes cancel to make debt policy irrelevant.

Question 60

Always use the average corporate tax rate to calculate the tax shields for firms.

Question 61

What is the relative tax advantage of debt when corporate and personal taxes are considered?

Question 62

A firm bankrupt from excess use of debt, which receives government bailout funds and government loan guarantees is incentivized to issue more high risk debt.

Question 63

Explain the pecking order theory of capital structure.

Question 64

Discuss the basic idea behind Miller's arguments about debt and taxes.

Question 65

State Modigliani-Miller's proposition I corrected to include corporate income taxes.

Question 66

Briefly explain how interest tax shields contribute to the value of stockholders' equity.

Question 67

Discuss some examples of the conflicts of interest that may arise between bondholders and stockholders when a firm is in financial distress.

Question 68

How does Modigliani-Miller's proposition I is modified when taxes and financial distress costs are considered?

Question 69

The pecking order theory implies that firms prefer internal to external financing.

Question 70

The existing tax code encourages a preference for equity over debt in corporate financing.

Question 71

Explain the impact of government loan guarantees on corporate financing.

Question 72

Briefly explain bankruptcy costs.

Question 73

State how the present value of tax shield is changed when personal taxes are included.

Question 74

Briefly explain the trade-off theory of capital structure.