Deck 15: Capital Structure: Limits to the Use of Debt

Question 1

The explicit and implicit costs associated with corporate default are referred to as the _____ costs of a firm.

A)flotation
B)default beta
C)direct bankruptcy
D)financial distress
E)indirect bankruptcy

Answer 1

financial distress

Question 2

In general,the capital structures used by U.S.firms:

A)tend to overweight debt in relation to equity.
B)are easily explained in terms of earnings volatility.
C)are easily explained by analyzing the types of assets owned by the various firms.
D)tend to be those which maximize the use of the firm's available tax shelters.
E)vary significantly across industries.

Answer 2

vary significantly across industries.

Question 3

Which one of the following statements concerning bankruptcy is correct?

A)Bondholders have a greater incentive than stockholders to keep a firm from filing for bankruptcy.
B)An indirect cost of bankruptcy is the loss of key employees.
C)Bankruptcy is sometimes used as a means to increase payroll costs.
D)The assets of a firm tend to increase in value when a firm is in financial distress.
E)The administrative costs incurred in a bankruptcy are considered indirect bankruptcy costs.

Answer 3

An indirect cost of bankruptcy is the loss of key employees.

Question 4

The optimal capital structure of a firm _____ the marketed claims and _____ the nonmarketed claims against the cash flows of the firm.

A)minimizes;minimizes
B)maximizes;maximizes
C)minimizes;maximizes
D)maximizes;minimizes
E)equates; (blank)

Question 5

Which of these will occur in a world with taxes and financial distress when a firm is operating at its optimal capital structure?
I.The debt-to-equity ratio will 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 will equal the increased bankruptcy costs of that debt.

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 6

Corporations in the U.S.tend to:

A)have extremely high debt-to-equity ratios.
B)rely less on equity financing than they should.
C)minimize taxes.
D)underutilize debt.
E)rely more heavily on bonds than stocks as the major source of financing.

Question 7

In a world with corporate taxes,MM theory implies that that all firms should:

A)maintain a constant value.
B)decrease in value as the leverage of the firm increases.
C)choose an all-debt capital structure.
D)select the capital structure that maximizes the firm's WACC.
E)select the capital structure that equates the marginal cost of debt with the marginal benefits.

Question 8

In principle,when does a firm become bankrupt?

A)When its equity value falls to zero
B)When a lender refuses to lend any additional funds to the firm
C)When its current ratio is less than one
D)When it is one day late paying a payment to a creditor
E)When a bankruptcy petition is filed with the court

Question 9

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

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

Question 10

The optimal capital structure of a firm:

A)will remain constant over time unless the firm makes an acquisition.
B)is unaffected by changes in the financial markets.
C)will be the same for all firms in the same industry.
D)places more emphasis on the operations than on the financing of the firm.
E)will vary over time as taxes and market conditions change.

Question 11

The explicit costs,such as the legal expenses,associated with corporate default are classified as _____ costs.

A)unlevered
B)beta conversion
C)direct bankruptcy
D)indirect bankruptcy
E)flotation

Question 12

The legal proceeding for liquidating or reorganizing a firm operating in default is called a:

A)tender offer.
B)bankruptcy.
C)merger.
D)takeover.
E)proxy fight.

Question 13

A legal attempt to financially restructure a failing firm so that it can continue operating as a going concern is called a:

A)merger.
B)reorganization.
C)liquidation.
D)repurchase program.
E)divestiture.

Question 14

A firm that has a negative net worth is said to be:

A)experiencing accounting insolvency.
B)in legal bankruptcy.
C)experiencing technical insolvency.
D)experiencing a business failure.
E)in Chapter 11 bankruptcy reorganization.

Question 15

The complete termination of a firm as a going business concern is called a:

A)merger.
B)repurchase program.
C)liquidation.
D)divestiture.
E)reorganization.

Question 16

Indirect bankruptcy costs:

A)effectively limit the amount of equity a firm issues.
B)serve as an incentive to increase the financial leverage of a firm.
C)tend to increase as the debt-equity ratio decreases.
D)include the costs incurred by a firm as it tries to avoid seeking bankruptcy protection.
E)include the legal and accounting fees incurred during the bankruptcy process.

Question 17

The value of a firm is maximized when the:

A)weighted average cost of capital is minimized.
B)levered cost of capital is maximized.
C)tax rate is zero.
D)cost of equity is maximized.
E)debt-equity ratio is minimized.

Question 18

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

A)less taxable income.
B)lower probability of financial distress.
C)substantial tax shields from other sources.
D)the lowest marginal tax rate.
E)the highest depreciation deductions.

Question 19

Which of these represent indirect costs of financial distress?
I.Court fees paid to a bankruptcy court
II.A firm's supplier requiring payment in cash rather than offering its normal credit terms
III.Cost of a manager's time spent renegotiating the terms of a debt to avoid bankruptcy
IV.Loss of a key employee concerned about job security and the future of the firm

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

Question 20

The optimal capital structure has been achieved when the:

A)weight of equity is equal to the weight of debt.
B)debt-to-equity ratio selected results in the lowest possible weighted average cost of capital.
C)firm is totally financed with debt.
D)debt-to-equity ratio is such that the cost of debt exceeds the cost of equity.
E)cost of equity is maximized.

Question 21

Which one of the following claims on a firm would be paid first in a bankruptcy liquidation if the court adheres to the absolute priority rule?

A)Government tax claims
B)Wages,salaries,and commissions
C)Consumer claims
D)Preferred stockholder dividends
E)Contributions to employee benefit plans

Question 22

Which one of the following statements is correct concerning a Chapter 7 bankruptcy?

A)A firm reorganizes its operations in an effort to return to being a viable concern.
B)A trustee will assume control of the firm's assets until those assets can be liquidated.
C)Chapter 7 bankruptcies are always involuntary on the part of the firm.
D)The claims of creditors are paid prior to the bankruptcy administrative costs.
E)The firm generally issues new shares of stock prior to coming out of to bankruptcy.

Question 23

Issuing debt instead of new equity in a closely held firm more likely causes owner-managers to:

A)work harder than they would if equity had been issued.
B)consume more perquisites because the cost is passed on to the debtholders.
C)enjoy more leisure time than they would with an equity issue.
D)accept more unprofitable projects.
E)shirk their duties as they have less capital at risk.

Question 24

Which one of these describes a bankruptcy situation known as a "cram down"?

A)The absolute priority rule forces common shareholder claims to the very bottom of the payee list.
B)Creditors are forced to accept a bankruptcy plan that they voted to reject.
C)The filing firm can be forced by the court to accept a plan submitted by the firm's creditors.
D)Shareholders are forced to forfeit all their of claims on the bankrupt firm.
E)A firm submits a reorganization plan simultaneously with its bankruptcy petition thereby forcing the court to agree to the submitted plan.

Question 25

A valuable firm will tend to:

A)see its stock price increase if it issues debt beyond its optimal debt level.
B)issue more debt than a less valuable firm of comparable size.
C)reduce its debt level as a positive signal for the firm.
D)issue debt,but only on a temporary basis purely to fool investors regarding the firm's value.
E)see its stock price increase when it announces an exchange offer that decreases its leverage.

Question 26

Which one of these statements most applies to a firm that is suffering from financial distress?

A)Bondholders will desire high risk projects in order to protect their investment.
B)Stockholders will increase their investment in the firm to protect their current investment.
C)Stockholders will generally prefer low-risk over high-risk projects.
D)Managers will tend to lower dividends in an effort to protect shareholder value.
E)Stockholders will bear the cost of selfish investment strategies through higher interest payments.

Question 27

Which one of these relationships will exist if a firm is operating under its optimal capital structure?

A)The net present value of the firm will equal zero.
B)The firm's cost of capital will equal the risk-free rate.
C)The present value of the financial distress costs will equal the present value of the tax shield on debt.
D)The value of the firm equal the maximum value obtainable according to the MM theories.
E)The firm will be financed with equal amounts of long-term debt and equity.

Question 28

Which of these represent a payment of a nonmarketed claim on a firm's cash flows?
I.Payment of a customer's liability claim
II.Principal repayment of a bond
III.Federal corporate tax payment
IV.Dividend payment

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

Question 29

Which one of these statements is correct for a levered firm?

A)An increase in tax rates will decrease the value of the firm.
B)An increase in financial distress costs increases the value of a firm.
C)To obtain its maximum value,a firm should select an all-equity capital structure.
D)The value of a firm is maximized when its cost of capital is also maximized.
E)The optimal level of debt for a firm results in the value of that firm being maximized.

Question 30

Which one of these statements is correct?

A)Only the nonmarketed claims of a firm can be bought and sold.
B)An increase in a firm's marketed claims will increase the total value of a firm.
C)The total value of a firm is independent of the firm's cash flows.
D)Managers try to maximize both marketed and nonmarketed claims in order to maximize total firm value.
E)The value of a firm's marketed claims can change with changes in the firm's capital structure.

Question 31

Which one of these best describes the relationship between bondholders and stockholders at a time when it appears the firm may be facing increased financial distress?

A)Stockholders have an incentive to underinvest in new projects to the detriment of bondholders.
B)Both parties tend to work together for the common good of the firm.
C)Both bondholders and stockholders will encourage the firm to take on new high risk projects.
D)Bondholders will tend to lower their required rate of interest so the firm can afford additional financing until its financial status improves.
E)Bondholders tend to milk the property at the expense of stockholders.

Question 32

Which one of these actions by a firm is an example of milking the property? Assume the firm is in a period of financial distress.

A)Repaying a bond that matured
B)Paying the semiannual bond interest
C)Paying an extra dividend
D)Cutting a regular dividend
E)Paying a regular dividend

Question 33

Which one of the following is true?

A)A firm with low anticipated profits will likely take on a high level of debt.
B)Investors will generally view an increase in debt as a positive sign of the firm's value.
C)Rational investors are likely to infer a higher firm value if a firm is all-equity financed.
D)Rational firms raise debt levels when profits are expected to decline.
E)High-growth firms with future positive net present value projects tend to have high levels of debt.

Question 34

A firm may file for Chapter 11 bankruptcy:
I.in an attempt to gain a competitive advantage.
II.using a prepack.
III.while allowing the current management to continue running the firm.
IV.even though it is not insolvent.

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

Question 35

Conflicts of interest between stockholders and bondholders are known as:

A)trustee costs.
B)financial distress costs.
C)dealer costs.
D)agency costs.
E)underwriting costs.

Question 36

Which of the following are common loan covenants? Assume each item applies only during the term of the loan.
I.Limit on future borrowing
II.Requirement that the borrower maintains a minimum stated level of net working capital
III.Limit on any sales or switches of assets
IV.Limit on the amount of dividends that can be paid

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

Question 37

The free cash flow hypothesis supports:

A)decreasing stockholder dividends to retain more cash within the firm.
B)reducing a firm's level of debt to save the cash currently being spent on interest payments.
C)increasing the debt portion of a firm's capital structure.
D)hiring managers with little or no stock ownership in the firm.
E)the idea that firms with high levels of free cash flow are more apt to make good acquisitions than firms with low levels.

Question 38

The protective covenants contained within a loan agreement:

A)impose restrictions on the lender.
B)are designed to protect the borrower's shareholders.
C)increase the borrower's flexibility.
D)tend in increase the bond's interest rate.
E)can increase the value of the borrowing firm.

Question 39

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:

A)issue convertible debt prior to straight debt to save funds.
B)use short-term debt to its maximum available limit prior to issuing long-term debt.
C)issue new equity first in order to retain internal funds and avoid interest costs.
D)issue new debt prior to new equity.
E)use internal financing prior to external financing.

Question 40

A firm is technically insolvent when:

A)the value of its stock declines by more than 50 percent in any given 12-month period.
B)the value of the firm's assets is less than the value of the firm's liabilities.
C)it files the legal forms petitioning for bankruptcy protection.
D)it is unable to meet its financial obligations.
E)it has a negative net worth on its balance sheet.

Question 41

ATC has a value of $70,000 in a good economy and $55,000 in a recession.The firm has $60,000 of debt.The probability of a recession is 50 percent.The firm is considering a project that would change the firm values to $73,000 in a good economy and $50,000 in a recession.If the firm accepts this project,the firm value will ______ and shareholder value will ______.

A)decrease by $1,000;decrease by $1,000
B)decrease by $2,000;decrease by $2,000
C)decrease by $1,000;increase by $1,500
D)increase by $1,500;increase by $1,500
E)increase by $1,500;decrease by $1,000

Question 42

Burger Queen has a value of $26,000 in a good economy and $17,000 in a recession.The firm has $20,000 of debt.The probability of a recession is 50 percent.The firm is considering a project that would change the firm values to $27,000 in a good economy and $15,000 in a recession.Will shareholders be willing to accept this project? Why or why not?

A)No;Because the project will lower firm value by $500
B)No;Because the project will lower shareholder value by $500
C)No;Because the firm will be worth less in a recession than it is currently
D)Yes;Because the project will increase both firm and shareholder value by $500
E)Yes;Because shareholder value will increase $500 at a cost of $1,000 to the bondholders

Question 43

Miller Tool plans on closing its doors after one more year.During its last year in business the firm expects to generate a cash flow of $89,000 if the economy booms and $61,000 if it does not.The probability of a boom is 30 percent.The firm has debt of $65,000 that is due in one year.That debt has a market value of $57,000 today.Ignore taxes.The current promised return on debt is ____ percent and the expected return on debt is ______ percent.

A)9.12;14.04
B)11.18;14.04
C)11.18;9.12
D)14.04;9.12
E)14.04;11.18

Question 44

Bart's Mart will have a value of $41,000 if the economy does well this next year and a value of $32,000 if the economy does poorly.The probability of a good economy is 65 percent.The firm owes its bondholders $12,000.What is the market value of the firm if it only operates for one more year?

A)$24,500
B)$14,650
C)$37,850
D)$36,500
E)$25,850

Question 45

Custer's has bonds outstanding with a face value of $162,000 that are selling at par.It also has 10,000 shares of stock outstanding that are selling for $32.30 a share.The all-equity value of the firm is $455,000.The tax rate is 35 percent.By what amount has the value of the firm been decreased by the expected bankruptcy costs? Assume there are no other claims on the firm.

A)$11,300
B)$18,600
C)$26,700
D)$0
E)$30,000

Question 46

Explain a Section 363 bankruptcy and identify its primary benefit over a traditional bankruptcy.

Question 47

Dairy Isle has a value of $41,000 in a good economy and $32,000 in a recession.The firm has $35,000 of debt.The probability of a recession is 50 percent.The firm is considering a project that would change the firm values to $43,000 in a good economy and $29,000 in a recession.Will shareholders be willing to accept this project? Why or why not?

A)No;Because the project will lower firm value by $500
B)No;Because the project will lower shareholder value by $500
C)No;Because the firm will be worth less in a recession than it is currently
D)Yes;Because the project will increase both firm and shareholder value by $1,000
E)Yes;Because shareholder value will increase $1,000 at a cost of $1,500 to the bondholders

Question 48

Establishing a capital structure for a firm is not simple.Although financial theory guides the process,there is no quantifiable formula to follow.However,there are key factors which should be considered as they affect the target ratio.List and explain three such factors.

Question 49

Kat owns and manages a small all-equity firm.If she works 40 hours a week,the firm's annual EBIT will be $41,000.If she increases her hours to 45 a week,EBIT will increase to $48,000.The firm has a current value of $190,000.Kat wants to expand the business and needs $114,000 to do so.The firm can borrow the needed funds at an interest rate of 7.5 percent or it can issue equity.Ignore taxes.Kat will prefer:

A)debt with a 40-hour week as that option provides her with the highest cash flow.
B)debt with a 45-hour week as her cash flow will be $7,000 greater than her next best option.
C)equity with a 45-hour week as her cash flow will be $8,550 higher than a 45-hour week with debt.
D)equity with a 40-hour week as that option provides her with the highest cash flow.
E)debt with a 45-hour week as her cash flow will be $40,550.

Question 50

The Sawmill plans on closing its doors after one more year.During its last year in business the firm expects to generate a cash flow of $74,000 if the economy booms and $57,000 if it does not.The probability of a boom is 15 percent.The firm has debt of $60,000 that is due in one year.That debt has a market value of $58,000 today.Ignore taxes.The current promised return on debt is ____ percent and the expected return on debt is ______ percent.

A)3.78;-1.16
B)3.45;-.95
C)2.02;3.78
D)3.45;2.67
E)2.67;3.45

Question 51

For next year,there is a 60 percent chance the economy will do well and Importers Unlimited will have a firm value of $321,000.If the economy tanks,the firm's value will decline to $241,000.The firm owes its bondholders $250,000.What is the value of this firm to its shareholders?

A)$42,600
B)$39,000
C)$71,000
D)$46,400
E)$139,000

Question 52

How might business risk affect the capital structure of a firm?

Question 53

The Window Store will have a value of $163,000 if the economy does well this coming year and a value of $142,000 if the economy does poorly.The probability of a good economy is 55 percent.The firm owes its bondholders $54,000.The firm will only operate for one more year.What is the value of this firm to its shareholders?

A)$98,500
B)$99,550
C)$100,450
D)$153,550
E)$154,450

Question 54

Firms on the brink of bankruptcy often work with their creditors to avoid a bankruptcy filing.Identify three options that a firm's creditors can offer a distressed firm to help that firm avoid filing for bankruptcy protection.Explain why creditors may be willing to provide these options.

Question 55

Cool Refreshments has bonds outstanding with a face value of $140,000 that are selling at par.It also has 15,000 shares of stock outstanding that are selling for $19.80 a share.The all-equity value of the firm is $395,000.The tax rate is 34 percent.What is the value of the financial distress costs? Assume there are no other claims on the firm.

A)$5,600
B)$4,800
C)$6,200
D)$5,100
E)$6,500

Question 56

Marcus owns and manages OLK which is an all-equity firm.If he works 40 hours a week,the firm's annual EBIT will be $68,000.If he increases his hours to 65 a week,EBIT will increase to $148,000.The firm has a current value of $680,000.Marcus wants to expand the business and needs $320,000 to do so.The firm can borrow the needed funds at an interest rate of 8 percent or it can issue equity.Ignore taxes.Marcus will prefer:

A)debt with a 40-hour week as that option provides him with the highest cash flow.
B)debt with a 65-hour week as his cash flow will be $11,000 greater than his next best option.
C)equity with a 65-hour week as his cash flow will be $100,640.
D)equity with a 40-hour week as that option provides him with the highest cash flow.
E)debt with a 65-hour week as his cash flow will be $21,760 higher than if he works 65 hours and shares his equity.