Deck 16: Capital Structure Policy

Question 1

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

Answer 1

True

Question 2

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

Answer 2

True

Question 3

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

Answer 3

True

Question 4

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

Question 5

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

Question 6

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

Question 7

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

Question 8

Indirect bankruptcy costs include changes in customer and supplier behavior that negatively affect the firm.

Question 9

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

Question 10

Minimizing the cost of a firm's financing activities also maximizes the total value of the firm.

Question 11

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

Question 12

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

Question 13

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

Question 14

Direct-bankruptcy costs are considered transactions costs and occur when a firm must navigate the bankruptcy process.

Question 15

Issuing debt is less expensive than issuing stock.

Question 16

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

Question 17

M&M Proposition 2 states that the required rate of return on a firm's stock is related to the debt-to-equity ratio.

Question 18

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

Question 19

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

Question 20

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

Question 21

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 22

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

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

Question 23

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

Question 24

The weighted average cost of capital (WACC) includes

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

Question 25

A firm'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 26

An operating lease is treated like a purchase for accounting purposes.

Question 27

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

Question 28

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

Question 29

The optimal capital structure of a firm

A) minimizes the cost of financing a firm's projects.
B) minimizes interest payments to creditors.
C) maximizes firm value.
D) both a and c.

Question 30

A financial restructuring

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

Question 31

M&M Proposition 2 states that the cost of a firm's common stock is related to

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

Question 32

Financial risk

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

Question 33

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

Question 34

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

Question 35

According to M&M Proposition 2, the cost of a firm'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 36

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

Question 37

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

Question 38

When a firm is in financial distress, stockholders would like to overinvest in positive NPV projects.

Question 39

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

A) stock.
B) bonds.
C) equity options.
D) preferred stock.

Question 40

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

Question 41

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

Question 42

Which of these statements about direct bankruptcy costs is not true?

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

Question 43

M&M Proposition 1: If Dynamo wishes to change its capital structure from 75 percent to 60 percent 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 44

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 45

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) $1.58 and $12.38
B) $23.55 and $75
C) $1.125 and $12.38
D) None of the above.

Question 46

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 and $26.25
B) $26.25 and $42
C) $160 and $37.50
D) $37.50 and $60

Question 47

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

A) Firms must pay corporate income taxes.
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 48

M&M Proposition 1: How much is Dynamo worth today?

A) $1,765
B) $1,500
C) $2,143
D) None of the above.

Question 49

M&M Proposition 2: Rubber Chicken Inc. currently has a capital structure that is 40% debt and 60% equity. If the firm'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 50

The use of debt financing

A) reduces agency costs between the stockholders and management by increasing the amount of risk the managers take.
B) increases agency costs between the stockholders 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 51

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 and $60
B) $60 and $15
C) $10.80 and $22.50
D) $22.50 and $10.80

Question 52

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 53

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 stockholder money.

Question 54

The underinvestment problem occurs in a financially distressed firm 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 55

M&M Proposition 1: How much are your cash flows today?

A) $12.38
B) $15
C) $4.50
D) $150

Question 56

Academic studies have estimated that the tax benefit of debt realized by firms is approximately

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

Question 57

M&M Proposition 2: Swirlpool, Inc., 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 58

M&M Proposition 2: Gangland Water Guns, Inc., has a debt-to-equity ratio of 0.5. If the firm'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) None of the above.

Question 59

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 60

Which of these is not an example of indirect bankruptcy costs?

A) A firm's customers become concerned about whether or not warranties will be honored.
B) Employees begin to leave the firm.
C) New accountants are brought in to help with the bankruptcy process.
D) A bankruptcy judge orders new projects to be halted.

Question 61

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 62

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 63

Agency costs: Given the payoffs of the project, what does the percent 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 64

M&M Proposition 2: What percent of the firm's costs are fixed, and what percent are variable with the added debt?

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

Question 65

Agency costs: Suppose that JMK, Inc., has debt with a face value of $100mm and assets worth $70mm. Firm management has just identified a project that will require an initial outlay of $10mm and will return a NPV of $16mm, risk-free. The firm currently has no cash. What would be the net return to shareholders if they took on this project?

A) $-10mm
B) $0mm
C) $26mm
D) $70mm

Question 66

M&M Proposition 2: Using the information for Bellamee from Question 64, 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 67

Agency costs: What will the equity value of UBM be in one-year without shareholders taking on the project?

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

Question 68

The benefits of debt: Packman Corporation has a reported EBIT of $500, which is expected to remain constant in perpetuity. If the firm 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 69

M&M Proposition 2: Bellamee, Inc., 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) None of the above

Question 70

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 firm'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 71

M&M Proposition 2: A firm 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 percent of the firm is financed with equity?

A) 50%
B) 60%
C) 70%
D) None of the above

Question 72

Agency costs: What is the expected value of the bonds to the lenders if the stockholders sell the debt?

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

Question 73

The benefits of debt. A firm plans to issue $1 million worth of debt at a YTM of 9%. The debt is trading at par. The firm'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

M&M Proposition 2: A firm has $300mm in outstanding debt and $900mm in outstanding equity. Its cost of equity is 11%, and its cost of debt is 7%. What is the appropriate WACC?

A) 6%
B) 8%
C) 9%
D) 10%

Question 75

M&M Proposition 2: Suppose revenues fall by $300. What is the percent change in net income with and without the debt? Assume that the total variable productions costs remain the same.

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

Question 76

M&M Proposition 2: What is the net income of Banana without and with the debt?

A) $500 and $484.2
B) $484.2 and $500
C) $500 and $465
D) $490 and $500

Question 77

The pecking order theory: A firm 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 percent of the project will be financed by debt?

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

Question 78

M&M Proposition 2: Suppose a firm has a cost of equity of 12%, a D/E or 1/6, and the YTM on its bonds is 7.5%. The risk-free rate is currently 3%. What is the current required rate of return on its assets and equity if the D/E is changed to 1/3?

A) 11.35% and 13.25%
B) 11.35% and 8.25%
C) 13.25% and 11.35%
D) None of the above.

Question 79

Agency costs: What is the expected value of the equity if the stockholders sell the debt?

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

Question 80

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

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