Deck 6: The Financing Decision

Question 1

In some instances,additional debt financing can encourage managers to act more in the interests of owners.

Answer 1

True

Question 2

Debt financing results in lower after-tax earnings relative to equity financing.

Answer 2

True

Question 3

Which of the following factors favor the issuance of debt in the financing decision?
I.Market signaling
II.Distress costs
III.Tax benefits
IV.Financial flexibility

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

Answer 3

I and III only

Question 4

The M&M irrelevance proposition assures financial managers that their choice between equity or debt financing will ultimately have no impact on firm value.

Question 5

Which of the following factors favor the issuance of debt in the financing decision?
I.Market signaling
II.Distress costs
III.Management incentives
IV.Financial flexibility

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

Question 6

The term "financial distress costs" includes which of the following?
I.Direct bankruptcy costs
II.Indirect bankruptcy costs
III.Direct costs related to being financially distressed,but not bankrupt
IV.Indirect costs related to being financially distressed,but not bankrupt

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

Question 7

The basic lesson of the M&M theory is that the value of a firm is dependent upon:

A) the firm's capital structure.
B) the total cash flow of the firm.
C) minimizing the marketed claims.
D) the amount of marketed claims to that firm.
E) the size of the stockholders' claims.

Question 8

Financial leverage:
i.increases expected ROE but does not affect its variability.II.increases breakeven sales,like operating leverage,but increases the rate of earnings per share growth once breakeven is achieved.III.is a fundamental financial variable affecting sustainable growth.IV.increases expected return and risk to owners.

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

Question 9

Which of the following is NOT a likely financing policy for a rapidly growing business?

A) Adopt a modest dividend payout policy that enables the company to finance most of its growth externally.
B) Borrow funds rather than limit growth,thereby limiting growth only as a last resort.
C) Maintain a conservative leverage ratio to ensure continuous access to financial markets.
D) If external financing is necessary,use debt to the point it does not affect financial flexibility.
E) None of the abovE.

Question 10

Which of the following is/are helpful for evaluating the effect of leverage on a company's risk and potential returns?
I.Estimated pro forma coverage ratios
II.The recognition that financing decisions do not affect firm or shareholder value
III.A range of earnings chart and proximity of expected EBIT to the breakeven value
IV.A conservative debt policy that obviates the need to evaluate risk

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

Question 11

Salinas Corporation has net income of $15 million per year on net sales of $90 million per year.It currently has no long-term debt,but is considering a debt issue of $20 million.The interest rate on the debt would be 7%.Salinas Corp.currently faces an effective tax rate of 40%.What would be the annual interest tax shield to Salinas Corp.if it goes through with the debt issuance?

A) $560,000
B) $1,400,000
C) $8,000,000
D) $20,000,000
Interest tax shield = interest rate × amount of debt × tax rate = 0.07 × 20,000,000 × 0.40= $560,000

Question 12

Which of the following is NOT an implication of the pecking order theory of capital structure?

A) On average,a firm's stock price drops when it announces an equity issue.
B) Firms may want to maintain a reserve of cash or unused borrowing capacity.
C) More-profitable firms (all else equal)should have higher debt ratios.
D) Firms may fail to undertake positive-NPV projects if they would have to be financed with a new issue of equity.

Question 13

When a company is in financial distress,its shareholders may have an incentive to undertake excessively risky investments.

Question 14

According to the pecking order theory proposed by Stewart Myers of MIT,which of the following are correct?
i.For financing needs,firms prefer to first tap internal sources such as retained profits and excess cash.II.There is an inverse relationship between a firm's profit level and its debt level.III.Firms prefer to issue new equity rather than source external debt.IV.A firm's capital structure is dictated by its need for external financing.

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

Question 15

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

A) typically result in debt-to-asset ratios between 60 and 80 percent.
B) tend to converge to the same proportions of debt and equity.
C) tend to be those that maximize the use of the firm's available tax shelters.
D) vary significantly across industries.
E) None of the abovE.

Question 16

The evidence indicates that,on average,a company's stock price declines when it announces a new issue of equity.

Question 17

The best financing choice is the one that:

A) sets the debt-to-assets ratio equal to 1.
B) trades off the tax disadvantage of debt against the signaling effects of equity.
C) maximizes expected cash flows.
D) ignores the false comfort of financial flexibility.
E) results in the lowest possible financial distress costs.

Question 18

If the maturity of a company's liabilities is less than that of its assets,the company incurs a refinancing risk.

Question 19

Which of the following factors favor the issuance of equity in the financing decision?
I.Market signaling
II.Distress costs
III.Management incentives
IV.Financial flexibility

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

Question 20

Homemade leverage is:

A) the incurrence of debt by a corporation in order to pay dividends to shareholders.
B) the exclusive use of debt to fund a corporate expansion project.
C) the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage.
D) best defined as an increase in a firm's debt-equity ratio.
E) the term used to describe the capital structure of a levered firm.

Question 21

Please refer to the financial information for Nile Holdings above.Nile must decide how to finance a $100 million investment.Assume Nile raises $100 million of new debt at the end of 2014,at an interest rate of 7%.a.Assuming Nile must make a $20 million payment on the new debt next year,calculate the firm's times-burden-covered ratio and times-common-covered ratio (i.e. ,the number of times EBIT could cover interest,principal payments,and dividends).b.As Nile's banker,would you be comfortable loaning the company this new debt? Briefly explain why,or for what reasons you'd be comfortable or uncomfortable.

Question 22

$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$ Squamish Equipment
$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$ Selected financial information
$\begin{array}{c}\begin{array}{lll}\hline \text { Expected net income after tax next year before new financing }\\ \text { Sinking-fund payments due next year on existing debt}\\ \text { Interest due next year on existing debt}\\ \text { Company tax rate}\\ \text { Common stock price, per share}\\ \text { Common shares outstanding}\\\hline\end{array}\begin{array}{r}\hline\$ 40 \text { million } \\\$ 14 \text { million } \\\$ 15 \text { million } \\36 \% \\\$ 20.00 \\18 \text { million } \\\hline\end{array}\end{array}$


-Please refer to the financial information for Squamish Equipment above.Calculate Squamish's earnings per share next year assuming Squamish raises $40 million of new debt at an interest rate of 7 percent.

A) 1.28
B) 2.00
C) 2.12
D) 2.22
E) 3.06

Question 23

$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$ Squamish Equipment
$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$ Selected financial information
$\begin{array}{c}\begin{array}{lll}\hline \text { Expected net income after tax next year before new financing }\\ \text { Sinking-fund payments due next year on existing debt}\\ \text { Interest due next year on existing debt}\\ \text { Company tax rate}\\ \text { Common stock price, per share}\\ \text { Common shares outstanding}\\\hline\end{array}\begin{array}{r}\hline\$ 40 \text { million } \\\$ 14 \text { million } \\\$ 15 \text { million } \\36 \% \\\$ 20.00 \\18 \text { million } \\\hline\end{array}\end{array}$


-Please refer to the financial information for Squamish Equipment above.Calculate Squamish's times-interest-earned ratio for next year assuming the firm raises $40 million of new debt at an interest rate of 7 percent.

A) 2.00
B) 3.09
C) 3.66
D) 4.35
E) None of the above

Question 24

An all-equity business has 200 million shares outstanding selling for $30 a share.Management believes that interest rates are unreasonably low and decides to execute a leveraged recapitalization (a recap).It will raise $750 million in debt and repurchase 25 million shares.a.What is the market value of the firm prior to the recap? What is the market value of equity?
b.Assuming the irrelevance proposition holds,what is the market value of the firm after the recap? What is the market value of equity?
c.Do equity shareholders appear to have gained or lost as a result of the recap? Please explain.

Question 25

Which of the following would not be considered a cost of financial distress?

A) Lack of interest tax shields
B) Bankruptcy costs
C) Excessive risk-taking by shareholders
D) Loss of customers or suppliers

Question 26

Please refer to the financial information for Nile Holdings above.Nile must decide how to finance a $100 million investment.Assume Nile raises $100 million of new debt at the end of 2014,at an interest rate of 7%.a.Calculate the firm's pro forma 2015 times-interest-earned (TIE)ratio.b.Calculate the percentage EBIT can fall (below expected EBIT)before interest coverage dips below 1.0.

Question 27

Under the simplifying assumptions of Modigliani and Miller,an increase in a firm's financial leverage will:

A) increase the variability in earnings per share.
B) reduce the operating risk of the firm.
C) increase the value of the firm.
D) decrease the value of the firm.

Question 28

Can a company incur costs of financial distress without ever going bankrupt? Explain.What is the nature of these costs?

Question 29

When considering the impact of distress costs on capital structure,which of the following facts should lead ABC Corporation to set a higher target debt ratio than XYZ Corporation (all else equal)?

A) ABC's cash flows from operations are less volatile than XYZ's.
B) ABC is a computer software firm,and XYZ is an electric utility.
C) ABC operates in a more competitive industry than XYZ.
D) ABC's assets have lower resale values than XYZ's assets.

Question 30

The interest tax shield has no value when a firm has:
i.no taxable income.II.debt-equity ratio of 1.III.zero debt.IV.no leverage.

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

Question 31

Kahuku Corporation has 100 million shares outstanding trading at $20 per share.The company announces its intention to raise $150 million by selling new shares.a.What do market signaling studies suggest will happen to Kahuku's stock price on the announcement date? Why?
b.How large a gain or loss in aggregate dollar terms do market signaling studies suggest existing Kahuku shareholders will experience on the announcement date?
c.What percentage of the value of Kahuku's existing equity prior to the announcement is this expected gain or loss?
d.At what price should Kahuku expect its existing shares to sell immediately after the announcement?

Question 32

Please refer to the financial information for Nile Holdings above.Nile must decide how to finance a $100 million investment.Calculate next year's times-burden-covered ratio and earnings per share if Nile sells 2 million new shares at $50 a share instead of raising new debt.

Question 33

"A firm can't use interest tax shields unless it has (taxable)income to shield." What does this statement imply for capital structure? Explain briefly,comparing the following two examples: a start-up biotech firm and an electric utility company.

Question 34

$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$ Squamish Equipment
$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$ Selected financial information
$\begin{array}{c}\begin{array}{lll}\hline \text { Expected net income after tax next year before new financing }\\ \text { Sinking-fund payments due next year on existing debt}\\ \text { Interest due next year on existing debt}\\ \text { Company tax rate}\\ \text { Common stock price, per share}\\ \text { Common shares outstanding}\\\hline\end{array}\begin{array}{r}\hline\$ 40 \text { million } \\\$ 14 \text { million } \\\$ 15 \text { million } \\36 \% \\\$ 20.00 \\18 \text { million } \\\hline\end{array}\end{array}$


-Please refer to the financial information for Squamish Equipment above.Calculate Squamish's times-burden-covered ratio for the next year assuming the firm raises $40 million of new debt at an interest rate of 7 percent and that annual sinking fund payments on the new debt will equal $8 million.

A) 1.01
B) 1.08
C) 1.38
D) 1.49
E) 1.95

Question 35

$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$ Squamish Equipment
$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$ Selected financial information
$\begin{array}{c}\begin{array}{lll}\hline \text { Expected net income after tax next year before new financing }\\ \text { Sinking-fund payments due next year on existing debt}\\ \text { Interest due next year on existing debt}\\ \text { Company tax rate}\\ \text { Common stock price, per share}\\ \text { Common shares outstanding}\\\hline\end{array}\begin{array}{r}\hline\$ 40 \text { million } \\\$ 14 \text { million } \\\$ 15 \text { million } \\36 \% \\\$ 20.00 \\18 \text { million } \\\hline\end{array}\end{array}$


-Please refer to the financial information for Squamish Equipment above.For next year,calculate Squamish's earnings per share if Squamish sells 2 million new shares at $20 a share.

A) 1.28
B) 1.39
C) 2.00
D) 2.22
E) 4.00

Question 36

According to the pecking order theory of capital structure,why do firms avoid issuing equity?

A) Because fees associated with issuing new equity are so high
B) Because they want to avoid dilution of earnings per share
C) Because they don't want to commit to paying dividends on the new equity
D) Because equity issuance signals that managers believe their stock is overvalued,which causes the price of the stock to fall

Question 37

Which of the following statements regarding interest tax shields is correct?

A) Taxes are reduced by the amount of a firm's interest-bearing debt.
B) Taxable income is reduced by the amount of a firm's interest-bearing debt.
C) Taxes are reduced by the amount of the interest on a firm's debt.
D) Taxable income is reduced by the amount of the interest on a firm's debt.

Question 38

Please refer to the financial information for Nile Holdings above.Nile must decide how to finance a $100 million investment.Calculate next year's earnings per share assuming Nile raises $100 million of new debt.

Question 39

$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$ Squamish Equipment
$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$ Selected financial information
$\begin{array}{c}\begin{array}{lll}\hline \text { Expected net income after tax next year before new financing }\\ \text { Sinking-fund payments due next year on existing debt}\\ \text { Interest due next year on existing debt}\\ \text { Company tax rate}\\ \text { Common stock price, per share}\\ \text { Common shares outstanding}\\\hline\end{array}\begin{array}{r}\hline\$ 40 \text { million } \\\$ 14 \text { million } \\\$ 15 \text { million } \\36 \% \\\$ 20.00 \\18 \text { million } \\\hline\end{array}\end{array}$


-Please refer to the financial information for Squamish Equipment above.For next year,calculate Squamish's times-burden-covered ratio if Squamish sells 2 million new shares at $20 a share.

A) 1.03
B) 1.38
C) 1.60
D) 1.89
E) 2.10

Question 40

Please refer to the financial information for Nile Holdings above.Nile must decide how to finance a $100 million investment.Suppose Nile expects $4.52 in EPS next year if it does not go through with the investment and associated financing.As a shareholder,to satisfy its funding needs for the investment opportunity,do you prefer the company issue $100 million in new debt at an interest rate of 7% and a payment of $20 million due on the debt next year,or issue 2 million shares of equity at a target price of $50? Show supporting calculations,and provide arguments and potential counter-arguments for your recommendation.