Question 1

Explain how a firm loses value during the bankruptcy process from both a creditors and a shareholders perspective.

Accepted Answer

The bankruptcy process is a legal procee...

Question 2

By definition,which of the following costs are included in the term "financial distress costs"?
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

Accepted Answer

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

Question 3

In each of the theories of capital structure,the cost of equity increases as the amount of debt increases.So why don't financial managers use as little debt as possible to keep the cost of equity down?
 After all,aren't financial managers supposed to maximize the value of a firm?

Accepted Answer

This question requires students to differentiate between the cost of equity and the weighted average cost of capital.In fact,it gets to the essence of capital structure theory: the firm trades off higher equity costs for lower debt costs.The shareholders benefit (to a point,according to the static theory)because their investment in the firm is leveraged,enhancing the return on their investment.Thus,even though the cost of equity rises,the overall cost of capital declines (again,up to a point according to the static theory)and firm value rises.

Question 4

Which one of the following will generally have the highest priority when assets are distributed in a bankruptcy proceeding?

Accepted Answer

A)  consumer claim
B)  dividend payment to preferred shareholder
C)  company contribution to the employees' retirement account
D)  payment to an unsecured creditor
E)  payment of employee wagesF) None of the above
G) A) and D)

Question 5

The Corner Bakery has a debt-equity ratio of 0.62.The firm's required return on assets is 14.2 percent and its cost of equity is 16.1 percent.What is the pre-tax cost of debt based on M & M Proposition II with no taxes?

Accepted Answer

A)  7.10 percent
B)  10.68 percent
C)  11.14 percent
D)  17.56 percent
E)  18.40 percentF) A) and B)
G) A) and E)

Question 6

Which one of the following has the greatest tendency to increase the percentage of debt included in the optimal capital structure of a firm?

Accepted Answer

A)  exceptionally high depreciation expenses
B)  very low marginal tax rate
C)  substantial tax shields from other sources
D)  low probabilities of financial distress
E)  minimal taxable incomeF) A) and B)
G) C) and D)

Question 7

An unlevered firm has a cost of capital of 17.5 percent and earnings before interest and taxes of $327,500.A levered firm with the same operations and assets has both a book value and a face value of debt of $650,000 with a 7.5 percent annual coupon.The applicable tax rate is 38 percent.What is the value of the levered firm?

Accepted Answer

A)  $1,397,212
B)  $1,398,256
C)  $1,402,509
D)  $1,407,286
E)  $1,414,414F) A) and D)
G) None of the above

Question 8

AA Tours is comparing two capital structures to determine how to best finance its operations.The first option consists of all equity financing.The second option is based on a debt-equity ratio of 0.45.What should AA Tours do if its expected earnings before interest and taxes (EBIT) are less than the break-even level? Assume there are no taxes.

Accepted Answer

A)  select the leverage option because the debt-equity ratio is less than 0.50
B)  select the leverage option since the expected EBIT is less than the break-even level
C)  select the unlevered option since the debt-equity ratio is less than 0.50
D)  select the unlevered option since the expected EBIT is less than the break-even level
E)  cannot be determined from the information providedF) A) and E)
G) All of the above

Question 9

Bright Morning Foods has expected earnings before interest and taxes of $48,600,an unlevered cost of capital of 13.2 percent,and debt with both a book and face value of $25,000.The debt has an 8.5 percent coupon.The tax rate is 34 percent.What is the value of the firm?

Accepted Answer

A)  $245,500
B)  $247,600
C)  $251,500
D)  $264,800
E)  $271,300F) A) and D)
G) A) and C)

Question 10

New Schools,Inc.expects an EBIT of $7,000 every year forever.The firm currently has no debt,and its cost of equity is 15 percent.The firm can borrow at 8 percent and the corporate tax rate is 34 percent.What will the value of the firm be if it converts to 50 percent debt?

Accepted Answer

A)  $31,796.47
B)  $36,036.00
C)  $37,407.16
D)  $37,552.08
E)  $38,119.30F) B) and D)
G) B) and C)

Question 11

Holly's is currently an all equity firm that has 9,000 shares of stock outstanding at a market price of $45 a share.The firm has decided to leverage its operations by issuing $120,000 of debt at an interest rate of 9.5 percent.This new debt will be used to repurchase shares of the outstanding stock.The restructuring is expected to increase the earnings per share.What is the minimum level of earnings before interest and taxes that the firm is expecting? Ignore taxes.

Accepted Answer

A)  $38,475
B)  $40,516
C)  $42,000
D)  $44,141
E)  $45,020F) A) and D)
G) B) and C)

Question 12

Draw the following two graphs,one above the other:
 In the top graph,plot firm value on the vertical axis and total debt on the horizontal axis.Use this graph to illustrate the value of a firm under M & M without taxes,M & M with taxes,and the static theory of capital structure.On the lower graph,plot the WACC on the vertical axis and the debt-equity ratio on the horizontal axis.Use this second graph to illustrate the value of the firm's WACC under M & M without taxes,M & M with taxes,and the static theory.Briefly explain what the two graphs reveal about firm value and its cost of capital under the three different theories.

Accepted Answer

The student should replicate and explain Figure 16.8 from the text.

Question 13

The present value of the interest tax shield is expressed as:

Accepted Answer

A)  (TC × 
D)  /RA.
B)  VU + (TC × 
D)  .
C)  [EBIT × (TC × 
D)  ]/RU.
D)  [EBIT × (TC × 
D)  ]/RA.
E)  TC × D.F) A) and C)
G) A) and B) E

Question 14

The static theory of capital structure advocates that the optimal capital structure for a firm:

Accepted Answer

A)  is dependent on a constant debt-equity ratio over time.
B)  remains fixed over time.
C)  is independent of the firm's tax rate.
D)  is independent of the firm's weighted average cost of capital.
E)  equates the tax savings from an additional dollar of debt to the increased bankruptcy costs related to that additional dollar of debt.F) A) and C)
G) A) and E)

Question 15

Winter's Toyland has a debt-equity ratio of 0.65.The pre-tax cost of debt is 8.7 percent and the required return on assets is 16.1 percent.What is the cost of equity if you ignore taxes?

Accepted Answer

A)  19.31 percent
B)  19.74 percent
C)  20.29 percent
D)  20.46 percent
E)  20.91 percentF) B) and E)
G) C) and E)

Question 16

Corporations in the U.S.tend to:

Accepted Answer

A)  minimize taxes.
B)  underutilize debt.
C)  rely less on equity financing than they should.
D)  have relatively similar debt-equity ratios across industry lines.
E)  rely more heavily on debt than on equity as the major source of financing.F) A) and E)
G) None of the above

Question 17

M & M Proposition I with no tax supports the argument that:

Accepted Answer

A)  business risk determines the return on assets.
B)  the cost of equity rises as leverage rises.
C)  the debt-equity ratio of a firm is completely irrelevant.
D)  a firm should borrow money to the point where the tax benefit from debt is equal to the cost of the increased probability of financial distress.
E)  homemade leverage is irrelevant.F) B) and D)
G) A) and B)

Question 18

Based on the M & M propositions with and without taxes,how much time should a financial manager spend analyzing the capital structure of a firm?
 What if the analysis is based on the static theory?

Accepted Answer

Under either M & M scenario,a financial ...

Question 19

Stacy owns 38 percent of The Town Centre.She has decided to retire and wants to sell all of her shares in this closely held,all equity firm.The other shareholders have agreed to have the firm borrow $650,000 to purchase her shares of stock.What is the total market value of The Town Centre? Ignore taxes.

Accepted Answer

A)  $1,710,526
B)  $1,748,219
C)  $1,771,089
D)  $1,801,406
E)  $1,808,649F) D) and E)
G) B) and E)

Question 20

L.A.Clothing has expected earnings before interest and taxes of $48,900,an unlevered cost of capital of 14.5 percent,and a tax rate of 34 percent.The company also has $8,000 of debt that carries a 7 percent coupon.The debt is selling at par value.What is the value of this firm?

Accepted Answer

A)  $222,579.31
B)  $223,333.33
C)  $224,108.16
D)  $225,299.31
E)  $225,476.91F) C) and D)
G) D) and E)

Exam 16: Financial Leverage and Capital Structure Policy

Explain how a firm loses value during the bankruptcy process from both a creditors and a shareholders perspective.

Correct Answer
verified
The bankruptcy process is a legal procee...
View Answer

By definition,which of the following costs are included in the term "financial distress costs"? 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

Correct Answer
verified

In each of the theories of capital structure,the cost of equity increases as the amount of debt increases.So why don't financial managers use as little debt as possible to keep the cost of equity down? After all,aren't financial managers supposed to maximize the value of a firm?

Which one of the following will generally have the highest priority when assets are distributed in a bankruptcy proceeding?

Correct Answer
verified

The Corner Bakery has a debt-equity ratio of 0.62.The firm's required return on assets is 14.2 percent and its cost of equity is 16.1 percent.What is the pre-tax cost of debt based on M & M Proposition II with no taxes?

Correct Answer
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Which one of the following has the greatest tendency to increase the percentage of debt included in the optimal capital structure of a firm?

Correct Answer
verified

Correct Answer
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Correct Answer
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Bright Morning Foods has expected earnings before interest and taxes of $48,600,an unlevered cost of capital of 13.2 percent,and debt with both a book and face value of $25,000.The debt has an 8.5 percent coupon.The tax rate is 34 percent.What is the value of the firm?

Correct Answer
verified

New Schools,Inc.expects an EBIT of $7,000 every year forever.The firm currently has no debt,and its cost of equity is 15 percent.The firm can borrow at 8 percent and the corporate tax rate is 34 percent.What will the value of the firm be if it converts to 50 percent debt?

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified
The student should replicate and explain Figure 16.8 from the text.

The present value of the interest tax shield is expressed as:

Correct Answer
verified
E

The static theory of capital structure advocates that the optimal capital structure for a firm:

Correct Answer
verified

Winter's Toyland has a debt-equity ratio of 0.65.The pre-tax cost of debt is 8.7 percent and the required return on assets is 16.1 percent.What is the cost of equity if you ignore taxes?

Correct Answer
verified

Corporations in the U.S.tend to:

Correct Answer
verified

M & M Proposition I with no tax supports the argument that:

Correct Answer
verified

Based on the M & M propositions with and without taxes,how much time should a financial manager spend analyzing the capital structure of a firm? What if the analysis is based on the static theory?

Correct Answer
verified
Under either M & M scenario,a financial ...
View Answer

Correct Answer
verified

L.A.Clothing has expected earnings before interest and taxes of $48,900,an unlevered cost of capital of 14.5 percent,and a tax rate of 34 percent.The company also has $8,000 of debt that carries a 7 percent coupon.The debt is selling at par value.What is the value of this firm?

Correct Answer
verified

Exam 16: Financial Leverage and Capital Structure Policy

Explain how a firm loses value during the bankruptcy process from both a creditors and a shareholders perspective.

Correct AnswerverifiedThe bankruptcy process is a legal procee...View AnswerShow Answer

By definition,which of the following costs are included in the term "financial distress costs"? 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

Correct AnswerverifiedShow Answer

In each of the theories of capital structure,the cost of equity increases as the amount of debt increases.So why don't financial managers use as little debt as possible to keep the cost of equity down? After all,aren't financial managers supposed to maximize the value of a firm?

Which one of the following will generally have the highest priority when assets are distributed in a bankruptcy proceeding?

Correct AnswerverifiedShow Answer

The Corner Bakery has a debt-equity ratio of 0.62.The firm's required return on assets is 14.2 percent and its cost of equity is 16.1 percent.What is the pre-tax cost of debt based on M & M Proposition II with no taxes?

Correct AnswerverifiedShow Answer

Which one of the following has the greatest tendency to increase the percentage of debt included in the optimal capital structure of a firm?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Bright Morning Foods has expected earnings before interest and taxes of $48,600,an unlevered cost of capital of 13.2 percent,and debt with both a book and face value of $25,000.The debt has an 8.5 percent coupon.The tax rate is 34 percent.What is the value of the firm?

Correct AnswerverifiedShow Answer

New Schools,Inc.expects an EBIT of $7,000 every year forever.The firm currently has no debt,and its cost of equity is 15 percent.The firm can borrow at 8 percent and the corporate tax rate is 34 percent.What will the value of the firm be if it converts to 50 percent debt?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedThe student should replicate and explain Figure 16.8 from the text.

The present value of the interest tax shield is expressed as:

Correct AnswerverifiedE

The static theory of capital structure advocates that the optimal capital structure for a firm:

Correct AnswerverifiedShow Answer

Winter's Toyland has a debt-equity ratio of 0.65.The pre-tax cost of debt is 8.7 percent and the required return on assets is 16.1 percent.What is the cost of equity if you ignore taxes?

Correct AnswerverifiedShow Answer

Corporations in the U.S.tend to:

Correct AnswerverifiedShow Answer

M & M Proposition I with no tax supports the argument that:

Correct AnswerverifiedShow Answer

Based on the M & M propositions with and without taxes,how much time should a financial manager spend analyzing the capital structure of a firm? What if the analysis is based on the static theory?

Correct AnswerverifiedUnder either M & M scenario,a financial ...View AnswerShow Answer

Correct AnswerverifiedShow Answer

L.A.Clothing has expected earnings before interest and taxes of $48,900,an unlevered cost of capital of 14.5 percent,and a tax rate of 34 percent.The company also has $8,000 of debt that carries a 7 percent coupon.The debt is selling at par value.What is the value of this firm?

Correct AnswerverifiedShow Answer

Correct Answer
verified
The bankruptcy process is a legal procee...
View Answer

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
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Correct Answer
verified

Correct Answer
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Correct Answer
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The student should replicate and explain Figure 16.8 from the text.

Correct Answer
verified
E

Correct Answer
verified

Correct Answer
verified

Correct Answer
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Correct Answer
verified

Correct Answer
verified
Under either M & M scenario,a financial ...
View Answer

Correct Answer
verified

Correct Answer
verified