Question 1

Dairy Isle has a value of $59,000 in a good economy and $48,000 in a recession.The firm has $50,000 of debt.The probability of a recession is 32 percent.The firm is considering a project that would change the firm values to $63,000 in a good economy and $46,000 in a recession.Which one of these statements correctly describes the effects of this project?

Accepted Answer

A) The bondholders and stockholders equally share the increase in firm valuation. 
B) The bondholders are unaffected by the project. 
C) The shareholders gain an amount equal to 68 percent of the increase in the firm's value. 
D) The shareholders gain $2,080 while the bondholders are unaffected. 
E) The project transfers $640 from bondholders to stockholders.

Question 2

The free cash flow hypothesis supports

Accepted Answer

A) decreasing stockholder dividends to retain more cash within the firm. 
B) reducing a firm's level of debt to reduce the amount of cash used to pay interest. 
C) increasing the debt portion of a firm's capital structure to increase firm value. 
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 3

Custer's has bonds outstanding with a face value of $98,000 that are selling at par.It also has 12,000 shares of stock outstanding that are selling for $25.90 a share.The all-equity value of the firm is $398,000.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.

Accepted Answer

A) $21,300 
B) $18,900 
C) $23,500 
D) $0 
E) $20,750

Question 4

Bart's Mart will have a value of $59,000 if the economy does well this next year and a value of $52,000 if the economy does poorly.The probability of a good economy is 72 percent.The firm owes its bondholders $12,000.What is the market value of the firm if it only operates for one more year?

Accepted Answer

A) $57,680 
B) $54,650 
C) $57,040 
D) $56,560 
E) $55,850

Question 5

Kat owns and manages a small all-equity firm.If she works 40 hours a week,the firm's annual EBIT will be $38,000.If she increases her hours to 45 a week,EBIT will increase to $43,000.The firm has a current value of $210,000.Kat wants to expand the business and needs $76,000 to do so.The firm can borrow the needed funds at an interest rate of 6.7 percent,or it can issue equity.Ignore taxes.Kat will prefer

Accepted Answer

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 $5,000 greater than her next best option. 
C) equity with a 45-hour week as her cash flow will be $5,006 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 $31,573.

Question 6

A firm is technically insolvent when

Accepted Answer

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 7

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

Accepted Answer

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 8

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

Accepted Answer

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 bankruptcy.

Question 9

The Sawmill expects to generate a cash flow of $59,000 next year if the economy booms and $46,000 if it does not.The probability of a boom is 20 percent.The firm has debt of $52,000 that is due in 1 year and has a current market value of $48,700.The firm plans to close after this coming year.The current promised pretax return on debt is ________ percent,and the expected pretax return on debt is ________ percent.

Accepted Answer

A) 6)78;1.16 
B) 6)78;-3.08 
C) 5)49;1.16 
D) 5)49;-2.67 
E) 6)27;-3.08

Question 10

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

Accepted Answer

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

Question 11

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

Accepted Answer

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 will 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 12

Cool Refreshments has bonds outstanding with a face value of $211,000 that are selling at par.It also has 14,000 shares of stock outstanding that are selling for $16.20 a share.The all-equity value of the firm is $408,000.The tax rate is 35 percent.What is the value of the financial distress costs? Assume there are no other claims on the firm.

Accepted Answer

A) $44,050 
B) $46,800 
C) $46,220 
D) $45,100 
E) $46,550

Question 13

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

Accepted Answer

A) minimizes;minimizes 
B) maximizes;maximizes 
C) minimizes;maximizes 
D) maximizes;minimizes

Question 14

A valuable firm will tend to:

Accepted Answer

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 15

Which one of the following is true?

Accepted Answer

A) A firm with low anticipated profits will likely take on a high level of debt. 
B) Investors will generally view an increase in leverage 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 16

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

Accepted Answer

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 17

The optimal debt-equity ratio tends to

Accepted Answer

A) remain constant when agency costs of equity are considered. 
B) support the all-debt capital structure. 
C) increase when agency costs of equity exist. 
D) be directly related to the costs of financial distress. 
E) decrease as the tax rate increases.

Question 18

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.

Question 19

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

Accepted Answer

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

Question 20

ATC has a value of $98,000 in a normal economy and $87,000 in a recession.The firm has $90,000 of debt.The probability of a recession is 18 percent.The firm is considering a project that would change the firm values to $105,000 in a good economy and $92,000 in a recession.If the firm accepts this project,the firm value will ________ and shareholder value will ________.

Accepted Answer

A) decrease by $2,000;decrease by $1,000 
B) increase by $2,000;increase by $2,000 
C) increase by $6,640;increase by $6,100 
D) increase by $12,000;increase by $12,000 
E) increase by $6,640;increase by $6,640

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