Deck 16: Capital Structure Policy

Question 1

Indirect insolvency costs will often increase when a company is in financial stress and may even push the company into insolvency.

Answer 1

True

Question 2

Issuing debt is less expensive than issuing shares.

Answer 2

True

Question 3

Direct-insolvency costs are considered transaction costs and occur when a company must navigate the insolvency process.

Answer 3

True

Question 4

Under the M&M assumptions with tax, the value of the company with debt is the value of the company without debt plus the present value of the interest tax shield.

Question 5

The enterprise value of a company is the value of equity minus the value of debt.

Question 6

M&M Proposition 2 states that the required rate of return on a company's shares are related to the debt-to-equity ratio.

Question 7

When a company gets closer to financial distress causing expected insolvency costs to increase, lenders will often charge the company a lower interest rate in order to reduce the chance of an actual insolvency occurring.

Question 8

M&M Proposition 1 states that the capital structure of a company does not affect the required rate of return on a company's assets, while M&M Proposition 2 shows that the required rate of return on company's equity does change with capital structure decisions.

Question 9

When calculating free cash flow, it is important to include interest and principal payments.

Question 10

Indirect insolvency costs include changes in customer and supplier behaviour that negatively affect the company.

Question 11

Unlike direct insolvency costs, indirect costs are not considered transactions costs.

Question 12

M&M Proposition 1 assumes that the mix of debt and equity that a company chooses does not affect real investment policy.

Question 13

Minimising the cost of a company's financing activities also maximises the total value of the company.

Question 14

Increasing a company's outstanding equity will increase company leverage.

Question 15

With no debt, the WACC is the cost of equity plus the required rate of return on the company's underlying assets.

Question 16

Direct insolvency costs are considered small when compared to indirect costs.

Question 17

More debt in the capital structure provides managers with an incentive to maximise cash flows, but also makes them want to take on negative NPV projects.

Question 18

If a company has debt and pays tax, the present value of the tax shield is the amount of debt outstanding times the tax rate.

Question 19

Insolvency and agency costs both act as limits on the amount of debt in the capital structure.

Question 20

A financial restructuring can change the value of a company's real assets, such as property, plant and equipment.

Question 21

The optimal capital structure of a company:

A) minimises the cost of financing a company's projects.
B) minimises interest payments to creditors.
C) maximises company value.
D) both a and c.

Question 22

Which of the following is a reason financial policy might matter?

A) Companies must pay corporate income tax.
B) Capital structure choices can affect investment decisions, such as R&D and PP&E.
C) Issuing equity is expensive.
D) All of the above.

Question 23

M&M Proposition 2 states that the cost of a company's ordinary shares are related to:

A) the debt-to-equity ratio.
B) the required rate of return on the company's underlying assets.
C) the return of the market index.
D) a and b.

Question 24

Without debt in the capital structure, there are no asset substitution or underinvestment problems.

Question 25

When a company is in financial distress, shareholders would wish to over-invest in positive NPV projects.

Question 26

Financial risk:

A) the effect that a company's financing decision has on the riskiness to cash flows.
B) increases a company's business risk.
C) decreases a company's business risk.
D) is related to how debt affects the business decisions of a company.

Question 27

Managers often focus on cash flows, but reported accounting earnings are a better indicator of the company's economic health.

Question 28

According to M&M Proposition 2, the cost of a company's equity:

A) increases with the debt-to-equity ratio.
B) decreases with the debt-to-equity ratio.
C) increases and then falls with the debt-to-equity ratio.
D) decreases and then increases with the debt-to-equity ratio.

Question 29

Companies have a difficult time selling equity when in financial distress.

Question 30

A company's capital structure is the mix of financial securities used to finance its activities and can include all of the following except:

A) shares.
B) bonds.
C) equity options.
D) preference shares.

Question 31

Under the pecking order theory, debt is factually the cheapest source of funds due to the interest tax shield.

Question 32

Industries with large amounts of tangible assets often use little debt.

Question 33

The trade-off theory of capital structure states that leverage is increased until the marginal cost of debt is equal to the marginal benefit.

Question 34

More profitable companies have less debt, which supports the trade-off theory.

Question 35

Dividends reduce the value of lender claims, and this is why bondholders often limit the company's ability to distribute cash to equity holders.

Question 36

A financial restructuring:

A) will not change the value of a company's real assets under M&M Proposition 1.
B) includes financial transactions that change the capital structure of the company.
C) means that a company has issued equity to retire debt.
D) both a and b.

Question 37

A company's enterprise value is given by:

A) the value of equity plus the value of debt.
B) the value of equity minus the value of debt.
C) the value of equity minus the value of debt plus the value of future projects.
D) none of the above.

Question 38

M&M Proposition 1 assumes all of the following except that:

A) there are no tax.
B) there are no costs to acquiring information.
C) there are no transactions costs.
D) the real investment policy of the company is affected by its capital structure decisions.

Question 39

The weighted average cost of capital (WACC) includes:

A) the required return on equity and required return on underlying company assets.
B) the cost of any debt and the cost of equity.
C) the cost of any debt and required return on underlying company assets.
D) none of the above.

Question 40

Borrowing money and paying out a special dividend to shareholders is an example of the asset substitution problem.

Question 41

Dynamo Company produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 per cent equity and 25 per cent debt. Your analysis tells you that the appropriate discount rates are 10 per cent for the cash flows, and 7 per cent for the debt. You currently own 10 per cent of the shares. M&M Proposition 1: How much of the special dividend do you receive, and how much do you receive in regular dividends per annum after the restructuring?

A) $15, $60
B) $60, $15
C) $10.80, $22.50
D) $22.50, $10.80

Question 42

Dynamo Company produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 per cent equity and 25 per cent debt. Your analysis tells you that the appropriate discount rates are 10 per cent for the cash flows, and 7 per cent for the debt. You currently own 10 per cent of the shares. M&M Proposition 1: How much does Dynamo currently pay in interest, and how much will it have to pay after the restructuring in the prior problem, assuming that the cost of debt is constant?

A) $42, $26.25
B) $26.25, $42
C) $160, $37.50
D) $37.50, $160

Question 43

Dynamo Company produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 per cent equity and 25 per cent debt. Your analysis tells you that the appropriate discount rates are 10 per cent for the cash flows, and 7 per cent for the debt. You currently own 10 per cent of the shares. M&M Proposition 1: According to M&M Proposition 1, what transaction do you need to take in order to undo the restructuring?

A) Sell $22.50 of equity.
B) Sell $10.80 worth of equity.
C) Buy $22.50 worth of debt.
D) Buy $10.80 worth of debt.

Question 44

The use of debt financing:

A) may cause a manager to take on riskier projects in order to make interest payments.
B) is more expensive than issuing equity due to the use of covenants.
C) allows managers to make discretionary interest payments.
D) limits the ability of managers to waste shareholder money.

Question 45

Dynamo Company produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 per cent equity and 25 per cent debt. Your analysis tells you that the appropriate discount rates are 10 per cent for the cash flows, and 7 per cent for the debt. You currently own 10 per cent of the shares. M&M Proposition 1: What are the interest payments that you receive after you undo the restructuring, and what are your total cash flows?

A) $1.57, $12.38
B) $23.55, $75
C) $1.13, $12.38
D) $1.24, $11.25

Question 46

In order to calculate the present value of debt tax savings, the _______ is used as the discount rate.

A) WACC
B) risk-free rate
C) required rate of return on debt
D) none of the above

Question 47

M&M Proposition 2: Melba's Toast has a capital structure with 30% debt and 70% equity. Its pretax cost of debt is 6%, and its cost of equity is 10%. The company's marginal corporate income tax rate is 35%. What is the appropriate WACC?

A) 8.17%
B) 6.35%
C) 8.80%
D) 7.44%

Question 48

The underinvestment problem occurs in a financially distressed company when:

A) the value of investing in a positive-NPV project is likely to go to debt holders instead of equity holders.
B) the value of investing in a positive-NPV project is likely to go to equity holders instead of debt holders.
C) management invests in negative-NPV projects to reduce their own risk.
D) issuing equity becomes difficult due to increased risk.

Question 49

Dynamo Company produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 per cent equity and 25 per cent debt. Your analysis tells you that the appropriate discount rates are 10 per cent for the cash flows, and 7 per cent for the debt. You currently own 10 per cent of the shares. M&M Proposition 1: How much are your cash flows today?

A) $12.38
B) $15
C) $11.25
D) $150

Question 50

M&M Proposition 2: A company has a WACC of 8.5%, a pretax cost of debt of 5%, a cost of equity of 12%, and a marginal corporate income tax rate of 35%. What per cent of the company is financed with equity?

A) 50%
B) 60%
C) 70%
D) 42.5%

Question 51

M&M Proposition 2: Nullaboor Ltd has a WACC of 11%, a cost of debt of 8%, and a cost of equity of 12%. What must the debt-to-equity ratio be?

A) 1/2
B) 1/4
C) 1/6
D) None of the above.

Question 52

M&M Proposition 2: Alto Pet Ltd. currently has a capital structure that is 40% debt and 60% equity. If the company's cost of equity is 12%, the cost of debt is 8%, and the risk-free rate is 3%, what is the appropriate WACC?

A) 8.4%
B) 9.6%
C) 10.4%
D) 9.2%

Question 53

Which of these statements about direct insolvency costs is NOT true?

A) Direct insolvency costs include the hiring of additional accountants, lawyers, and consultants.
B) Direct insolvency costs are less than indirect costs.
C) Suppliers requiring cash on delivery forms part of a company's direct insolvency costs.
D) Negotiating with lenders may help a company reduce direct insolvency costs.

Question 54

Dynamo Company produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 per cent equity and 25 per cent debt. Your analysis tells you that the appropriate discount rates are 10 per cent for the cash flows, and 7 per cent for the debt. You currently own 10 per cent of the shares. M&M Proposition 1: How much is Dynamo worth today?

A) $1,765
B) $1,500
C) $2,143
D) $1,125.

Question 55

The use of debt financing:

A) reduces agency costs between the shareholders and management by increasing the amount of risk the managers take.
B) increases agency costs between the shareholders and management by limiting the amount of risk the managers take.
C) increases agency costs since managers prefer to keep more retained earnings rather than pay a dividend.
D) b and c.

Question 56

The asset substitution problem occurs when:

A) managers substitute riskier assets for less risky ones to the detriment of bondholders.
B) managers substitute less risky assets for riskier ones to the detriment of bondholders.
C) managers substitute riskier assets for less risky ones to the detriment of equity holders.
D) managers substitute less risky assets for riskier ones to the detriment of equity holders.

Question 57

The interest tax shield:

A) does not affect the WACC.
B) makes it less costly to distribute cash to the security holder through interest payments than through dividends.
C) is given by D × (1 - t).
D) b and c.

Question 58

Academic studies have estimated that the tax benefit of debt realised by companies is approximately:

A) 10% of company value.
B) a 10% reduction in WACC.
C) a 10% reduction in the cost of debt
D) 10% of debt value.

Question 59

M&M Proposition 2: X-Pool Filters Ltd has a debt-to-equity ratio of 0.5. If the company's cost of debt is 7% and its cost of equity is 13%, what is the appropriate WACC?

A) 9%
B) 10%
C) 11%
D) 13%.

Question 60

Dynamo Company produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 per cent equity and 25 per cent debt. Your analysis tells you that the appropriate discount rates are 10 per cent for the cash flows, and 7 per cent for the debt. You currently own 10 per cent of the shares. M&M Proposition 1: If Dynamo wishes to change its capital structure from 75 per cent to 60 per cent equity and use the debt proceeds to pay a special dividend to shareholders, how much debt should they issue?

A) $321
B) $375
C) $600
D) $225

Question 61

Outflung Computers has $1,000 in revenue this year, along with COGS of $400 and SG&A of $100. The required rate of return on its equity is 14%, and the risk-free rate is 5%. Assume that the COGS only includes the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5% and a YTM of 7.9% to its capital structure. M&M Proposition 2: Suppose revenues fall by $300. What is the per cent change in profit with and without the debt? Assume that the total variable productions costs remain the same.

A) 64.5%, 60%
B) 60%, 64.5%
C) 59.2%, 40.8%
D) 40.8%, 59.2%

Question 62

The benefits of debt: Packman Company has a reported EBIT of $500, which is expected to remain constant in perpetuity. If the company borrows $2,000, its YTM will be 6.5% and its coupon rate will be 8%. If the company's marginal tax rate is 30% and its average tax rate is 20%, what are its after-tax earnings?

A) $238
B) $272
C) $259
D) None of the above.

Question 63

M&M Proposition 2: Bellamee Ltd has a required rate of return on its assets of 12% and a cost of debt of 6.25%. Their current debt-to-equity ratio is 1/5. What is the required rate of return on their equity?

A) 12.15%
B) 13.15%
C) 14.15%
D) 10.4%

Question 64

Suppose that USB Corp has $100m invested in 8% risk-free bonds that mature in one-year. The company also has $80m in debt outstanding that will also mature in a year. USB shareholders are considering selling the $100m in debt and investing in a project that has a 60% chance of returning $200m and a 40% chance of returning $2m. Agency costs: What will the equity value of USB be in one-year without shareholders taking on the project?

A) $100m
B) $80m
C) $20m
D) $8m

Question 65

The benefits of debt: A company plans to issue $1 million worth of debt at a YTM of 9%. The debt is trading at par. The company's marginal corporate tax rate is 25%, while its average tax rate is 15%. By how much will this debt issuance reduce the company's annual tax liability?

A) $13,500
B) $22,500
C) $32,500
D) None of the above.

Question 66

Suppose that USB Corp has $100m invested in 8% risk-free bonds that mature in one-year. The company also has $80m in debt outstanding that will also mature in a year. USB shareholders are considering selling the $100m in debt and investing in a project that has a 60% chance of returning $200m and a 40% chance of returning $2m. Agency costs: What is the expected value of the equity if the shareholders sell the debt?

A) $175m
B) $97.5m
C) $51m
D) None of the above.

Question 67

Which of the following supports the trade-off theory of capital structure?

A) Companies use cash on hand first, since issuing equity and debt is expensive.
B) A company's capital structure is the result of past equity and debt issuance decisions.
C) Companies have a target capital structure.
D) a and b.

Question 68

Outflung Computers has $1,000 in revenue this year, along with COGS of $400 and SG&A of $100. The required rate of return on its equity is 14%, and the risk-free rate is 5%. Assume that the COGS only includes the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5% and a YTM of 7.9% to its capital structure. M&M Proposition 2: What per cent of the company's costs are fixed, and what per cent are variable with the debt and without the change in leverage?

A) 27.9%, 72.1%
B) 72.1%, 27.9%
C) 25.23, 74.77%
D) 74.77%, 25.23%

Question 69

The pecking order theory: A company wishes to undertake a project that costs $150mm. It currently has $10mm in cash on hand and believes that it can raise $75mm in debt and $100mm in equity if needed. According to the pecking order theory of the capital structure, what per cent of the project will be financed by debt?

A) 0%
B) 26.67%
C) 50%
D) None of the above

Question 70

Millennium Motors has current pretax annual cash flows of $1,000 and is in the 35% tax bracket. The appropriate discount rate for its cash flows is 12%. Suppose the company issues a $1,500 bond and uses these proceeds to pay a one-time special dividend to shareholders. The cost of equity: What is its value without debt in the capital structure?

A) $350
B) $650
C) $2,917
D) $5,417

Question 71

Millennium Motors has current pretax annual cash flows of $1,000 and is in the 35% tax bracket. The appropriate discount rate for its cash flows is 12%. Suppose the company issues a $1,500 bond and uses these proceeds to pay a one-time special dividend to shareholders. The cost of equity: What is Millennium's value after the debt issuance?

A) $5,417
B) $5,942
C) $6,392
D) None of the above.

Question 72

Suppose that USB Corp has $100m invested in 8% risk-free bonds that mature in one-year. The company also has $80m in debt outstanding that will also mature in a year. USB shareholders are considering selling the $100m in debt and investing in a project that has a 60% chance of returning $200m and a 40% chance of returning $2m. Agency costs: What is the expected value of the bonds if the shareholders sell the debt?

A) $100m
B) $88.8m
C) $48.8m
D) None of the above.

Question 73

The benefits of debt. A company plans to issue $1 million worth of debt at a YTM of 9%. The debt is trading at par. The company's marginal corporate tax rate is 35%. What is the present value of the tax savings in perpetuity?

A) $11,025
B) $20,475
C) $350,000
D) $227,500

Question 74

One of the conditions that the M&M Propositions required was for there to be no tax. Briefly discuss whether the introduction of tax decreases or increases the value of the company.

Question 75

Suppose that USB Corp has $100m invested in 8% risk-free bonds that mature in one-year. The company also has $80m in debt outstanding that will also mature in a year. USB shareholders are considering selling the $100m in debt and investing in a project that has a 60% chance of returning $200m and a 40% chance of returning $2m. Agency costs: Given the pay-offs of the project, what does the per cent chance of success need to be in order for the expected value of equity with the project to be equal to the expected value of equity without the project?

A) 1/3
B) 1/4
C) 1/5
D) 1/6

Question 76

M&M Proposition 2: Bellamee Ltd has a required rate of return on its assets of 12% and a cost of debt of 6.25%. Their current debt-to-equity ratio is 1/5. What is its required return on equity if its debt-to-equity ratio changes to 2/5 and this increases the required rate of return on their debt to 7%?

A) 14%
B) 14.25%
C) 14.50%
D) 15%

Question 77

The pecking order theory of capital structure suggests that managers will choose to utilise retained earnings before issuing additional debt when financing new projects. Does that imply anything about the flotation costs of issuing new securities?

Question 78

Ouflung Computers has $1,000 in revenue this year, along with COGS of $400 and SG&A of $100. The required rate of return on its equity is 14%, and the risk-free rate is 5%. Assume that the COGS only includes the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5% and a YTM of 7.9% to its capital structure M&M Proposition 2: What is the profit of Outflung without and with the debt?

A) $500, $484.20
B) $484.20, $500
C) $500, $465
D) $490, $500

Question 79

Briefly explain how an increase in the amount of debt that a company has outstanding may actually decrease the agency costs caused by the conflict between managers and shareholders.