Question 1

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)  minimizes; maximizes
C)  maximizes; minimizes
D)  maximizes; maximizes
E)  equates; (leave blank)  C

Question 2

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. B

Question 3

The value of a firm is maximized when the:

Accepted Answer

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

Question 4

When shareholders pursue selfish strategies such as taking large risks or paying excessive dividends, these will result in:

Accepted Answer

A)  no action by debtholders since these are equity holder concerns.
B)  positive agency costs, as bondholders impose various restrictions and covenants which will diminish firm value.
C)  investments of the same risk class that the firm is in.
D)  undertaking scale enhancing projects.
E)  lower agency costs, as shareholders have more control over the firm's assets.

Question 5

The optimal capital structure:

Accepted Answer

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

Question 6

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

Accepted Answer

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

Question 7

Given the following information, leverage will add how much value to the unlevered firm per dollar of debt? Corporate tax rate: 40%
Personal tax rate on income from bonds: 20%
Personal tax rate on income from stocks: 30%

Accepted Answer

A)  $-0.475
B)  $0.475
C)  $0.525
D)  $0.633
E)  None of the above

Question 8

When graphing firm value against debt levels, the debt level that maximizes the value of the firm is the level where:

Accepted Answer

A)  the increase in the present value of distress costs from an additional dollar of debt is greater than the increase in the present value of the debt tax shield.
B)  the increase in the present value of distress costs from an additional dollar of debt is equal to the increase in the present value of the debt tax shield.
C)  the increase in the present value of distress costs from an additional dollar of debt is less than the increase of the present value of the debt tax shield.
D)  distress costs as well as debt tax shields are zero.
E)  distress costs as well as debt tax shields are maximized.

Question 9

Holly Berry Incorporated will earn $40 in one year if it does well.The debtholders are promised payments of $25 in one year if the firm does well.If the firm does poorly, expected earnings in one year will be $20 and the repayment will be $15 because of the dead weight cost of bankruptcy.The probability of the firm performing poorly or well is 50%.If bondholders are fully aware of these costs what will they pay for the debt? The interest rate on the bonds is 8%.

Accepted Answer

A)  $18.52
B)  $30.00
C)  $32.55
D)  $35.75
E)  $37.04

Question 10

Which of the following industries would tend to have the highest leverage?

Accepted Answer

A)  Drugs
B)  Computer
C)  Paper
D)  Electronics
E)  Biological products

Question 11

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)  indirect bankruptcy
E)  financial distress

Question 12

Describe some of the sources of business risk and financial risk.Do financial decision makers have the ability to "trade off" one type of risk for the other?

Accepted Answer

The answer of Describe some of the sources of business...

Question 13

The Aggie Company has EBIT of $70,000 and market value debt of $100,000 outstanding with a 9% coupon rate.The cost of equity for an all equity firm would be 14%.Aggie has a 35% corporate tax rate.Investors face a 20% tax rate on debt receipts and a 15% rate on equity.Determine the value of Aggie.

Accepted Answer

A)  $120,000
B)  $162,948
C)  $258,537
D)  $263,080
E)  $355,938

Question 14

Your firm has a debt-equity ratio of .60.Your cost of equity is 11% and your after-tax cost of debt is 7%.What will your cost of equity be if the target capital structure becomes a 50/50 mix of debt and equity?

Accepted Answer

A)  9.50%
B)  10.50%
C)  11.00%
D)  11.25%
E)  12.00%

Question 15

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 16

Wigdor Manufacturing is currently all equity financed, has an EBIT of $2 million, and is in the 34% tax bracket. Louis, the company's founder, is the lone shareholder.
-If the firm were to convert $4 million of equity into debt at a cost of 10%, what would be the total cash flow to Louis if he holds all the debt? Compare this to Louis' total cash flow if the firm remains unlevered.

Accepted Answer

The answer of Wigdor Manufacturing is currently all equity financed,...

Question 17

The Do-All-Right Marketing Research firm has promised payments to its bondholders that total $100.The company believes that there is a 85% chance that the cash flow will be sufficient to meet these claims.However, there is a 15% chance that cash flows will fall short, in which case total earnings are expected to be $65.If the bonds sell in the market for $84, what is an estimate of the bankruptcy costs for Do-All-Right? Assume a cost of debt of 10%.

Accepted Answer

The answer of The Do-All-Right Marketing Research firm has promised...

Question 18

Studies have found that firms with high proportions of intangible assets are likely to use ____________ debt compared with firms with low proportions of intangible assets.

Accepted Answer

A)  more
B)  the same amount of
C)  less
D)  either more or the same amount of
E)  any amount of debt

Question 19

Given realistic estimates of the probability and cost of bankruptcy, the future costs of a possible bankruptcy are borne by:

Accepted Answer

A)  all investors in the firm.
B)  debtholders only because if default occurs interest and principal payments are not made.
C)  shareholders because debtholders will pay less for the debt providing less cash for the shareholders.
D)  management because if the firm defaults they will lose their jobs.
E)  None of the above.

Question 20

One of the indirect costs to bankruptcy is the incentive toward underinvestment.Following this strategy may result in:

Accepted Answer

A)  the firm always choosing projects with the positive NPVs.
B)  the firm turning down positive NPV projects that it would clearly accept in an all equity firm.
C)  stockholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the benefits of the project.
D)  Both A and C.
E)  Both B and C.

Exam 17: Capital Structure: Limits to the Use of Debt

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