Deck 18: How Much Should a Corporation Borrow

Question 1

Suppose that a company can direct $1 to either debt interest or capital gains for equity investors.If there were no personal taxes on capital gains, which of the following investors would not care how the money was channeled? (The marginal corporate tax rate is 35 percent.)

A)Investors paying personal tax of 17.5 percent
B)Investors paying personal tax of 35 percent
C)Investors paying personal tax of 53 percent
D)Tax-exempt personal investors

Answer 1

Investors paying personal tax of 35 percent

Question 2

MM's Proposition I corrected for the inclusion of corporate income taxes is expressed as

A)V_L = V_U.
B)V_L = V_U + D(1 - T_C).
C)V_L = V_U + (T_C)(D).
D)V_U = V_L + (T_C)(D).

Answer 2

V_L = V_U + (T_C)(D).

Question 3

Why does MM Proposition I not hold in the presence of corporate taxes?

A)Levered firms pay lower taxes when compared with identical unlevered firms.
B)Bondholders require higher rates of return compared with stockholders.
C)Earnings per share are no longer relevant with taxes.
D)Dividends are no longer relevant with taxes.

Answer 3

Levered firms pay lower taxes when compared with identical unlevered firms.

Question 4

For every dollar of operating income paid out as equity income, the shareholder realizes

A)(1 - Tp).
B)(1 - Tp_E) (1 - T_C).
C)(1 - T_c).
D)1/(1 - T_P).

Question 5

If a corporation cannot use its interest payments as a tax shield for a particular year because it has suffered a loss, it is still possible to use the tax shield because

A)the carry-back provision allows corporations to carry back the loss and receive a tax refund up to the amount of taxes paid in the previous two years.
B)the carry-forward provision allows corporations to carry forward the loss and use it to shield income in subsequent years.
C)the carry-back provision allows corporations to carry back the loss and receive a tax refund up to the amount of taxes paid in the previous two years and allows corporations to carry forward the loss and use it to shield income in subsequent years.
D)the firm will lose the tax shield.

Question 6

Given corporate taxes, why does adding debt to the capital structure increase firm value?

A)Extra cash flow goes to the firm's investors rather than the tax authorities.
B)Earnings before interest and taxes are fully taxed at the corporate rate.
C)Personal tax rates are the same as marginal corporate tax rates.
D)Earnings before interest and taxes are fully taxed at the corporate rate, and personal tax rates are the same as marginal corporate tax rates.

Question 7

For every dollar of operating income paid out as interest, the bondholder realizes

A)(1 - Tp).
B)(1 - Tp_E) (1 - T_C).
C)(1 - T_C).
D)1/(1 - T_C).

Question 8

If a firm permanently borrows $100 million at an interest rate of 8 percent, what is the present value of the interest tax shield? (Assume that the marginal corporate tax rate is 30 percent.)

A)$8 million
B)$5.60 million
C)$30 million
D)$26.67 million

Question 9

The main advantage of debt financing for a firm is that

A)no SEC registration is required for bond issues.
B)interest expenses are tax deductible.
C)unlevered firms have higher value than levered firms.
D)no SEC registration is required for bond issues, and unlevered firms have higher value than levered firms.

Question 10

If a firm borrows $50 million for one year at an interest rate of 10 percent, what is the present value of the interest tax shield? Assume a 30 percent marginal corporate tax rate.

A)$1.36 million
B)$1.50 million
C)$1 million
D)$4.55 million

Question 11

Assuming that bonds are sold at a fair price, the benefits from the interest tax shield go to the

A)managers of the firm.
B)bondholders of the firm.
C)stockholders of the firm.
D)lawyers of the firm.

Question 12

If a firm permanently borrows $50 million at an interest rate of 10 percent, what is the present value of the interest tax shield? Assume a 30 percent marginal corporate tax rate.

A)$50 million
B)$25 million
C)$15 million
D)$1.5 million

Question 13

Assume the marginal corporate tax rate is 30 percent.The firm has no debt in its capital structure.It is valued at $100 million.What would be the value of the firm if it issued $50 million in perpetual debt and repurchased the same amount of equity?

A)$65 million
B)$115 million
C)$100 million
D)$150 million

Question 14

In order to calculate the tax shield of interest payments for a corporation, always use the

A)average corporate tax rate.
B)marginal corporate tax rate.
C)marginal rate on personal income tax.
D)average corporate tax rate and marginal rate on personal income tax.

Question 15

If a firm borrows $50 million for one year at an interest rate of 9 percent, what is the present value of the interest tax shield? Assume a 30 percent marginal corporate tax rate.

A)$50 million
B)$17.50 million
C)$1.45 million
D)$1.24 million

Question 16

Bombay Company's book and market value balance sheets are as follows: (NWC = net working capital; LTA = long term assets; D = debt; E = equity; V = firm value):
$\quad$$\underline {\text { Book Values }}$ $\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$ $\underline {\text { Market Values }}$
$\begin{array}{lrrrlrrr}\text { NWC } & 200 & 500 & \text { D } & \text { NWC } & 200 & 500 & \text { D } \\\text { LTA } & \underline {2,300} & \underline {2,000} & \text { E } & \text { LTA } & \underline {2,800} & \underline {2,500} & \text { E }\\&2,500 & 2,500 & V & &3,000 & 3,000 & V\\\end{array}$ According to MM's Proposition I corrected for taxes, what will be the change in company value if Bombay issues $200 of equity and uses it to make a permanent reduction in the company's debt? Assume a 35 percent marginal corporate tax rate.

A)+$140
B)+$70
C)$0
D)?$70

Question 17

In order to calculate the tax shields provided by debt, the tax rate used is the

A)average corporate tax rate.
B)marginal corporate tax rate.
C)average of shareholders' equity tax rates.
D)average of bondholders' personal tax rates.

Question 18

In order to find the present value of the tax shields provided by debt, the discount rate used is the

A)cost of capital.
B)cost of equity.
C)cost of debt.
D)T-bill rate.

Question 19

MM Proposition I with corporate taxes states that

A)capital structure can affect firm value by an amount that is equal to the present value of the interest tax shield.
B)by raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total value.
C)firm value is maximized by using an all-equity capital structure.
D)capital structure can affect firm value by an amount that is equal to the present value of the interest tax shield; and, by raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total value.

Question 20

What is the relative tax advantage of debt? Assume that personal and corporate taxes are given by T_C = (corporate tax rate) = 35 percent; Tp_E = personal tax rate on equity income = 30 percent; and Tp = personal tax rate on interest income = 20 percent.

A)1.76
B)1.16
C)1.35
D)0.86

Question 21

What does "risk shifting" imply?

A)When faced with bankruptcy, managers tend to invest in high-risk, high-return projects.
B)When faced with bankruptcy, managers do not invest more equity capital.
C)When faced with bankruptcy, managers may make accounting changes to conceal the true extent of the problem.
D)When faced with bankruptcy, managers invest in low-risk projects to conserve capital.

Question 22

When financial distress is a possibility, the value of a levered firm is a function of the

A)value of the firm if all-equity-financed.
B)value of the firm if all-equity-financed plus the present value of tax shield.
C)value of the firm if all-equity-financed plus the present value of tax shield minus the present value of costs of financial distress.
D)value of the firm if all-equity-financed plus the present value of tax shield minus the present value of costs of financial distress minus the present value of omitted dividend payments.

Question 23

Suppose that your firm's current unlevered value, V*, is $800,000, and its marginal corporate tax rate is 35 percent.Also, you model the firm's PV of financial distress as a function of its debt level according to the relation: PV of financial distress = 800,000 × (D/V*)2.What is the firm's levered value if it issues $200,000 of perpetual debt to buy back stock?

A)$820,000.
B)$869,555.
C)$920,000.
D)$350,000.

Question 24

Which of the following is not a potential result from financial distress?

A)Suppliers refuse to extend terms to the firm.
B)Key employees leave the firm, fearing the firm won't last.
C)The firm has difficulty issuing additional bonds.
D)Due to interest tax shields, the firm's effective tax rate is very low.

Question 25

Firm A and Firm B are identical except that A is incorporated while B is an unlimited liability partnership.Both have assets worth $500,000 ($500K) funded with a debt ratio of 40 percent.Suppose that the assets suddenly become worthless.What is the maximum possible loss to the equityholders of each company?

A)Firm A: $300K; Firm B: $500K
B)Firm A: $200K; Firm B: $300K
C)Firm A: $500K; Firm B: $200K
D)Firm A: $500K; Firm B: $500K

Question 26

In Miller's model, when the quantity (1 - T_C)(1 - Tp_E) = (1 - Tp), then

A)the firm should hold no debt.
B)the value of the levered firm is greater than the value of the unlevered firm.
C)the tax shield on debt is exactly offset by higher personal taxes paid on interest income.
D)the firm should be financed by 100 percent equity.

Question 27

When faced with financial distress, managers of firms acting on behalf of their shareholders' interests will tend to

A)favor high-risk, high-return projects even if they have negative NPV.
B)refuse to invest in low-risk, low-return projects with positive NPVs.
C)delay the onset of bankruptcy as long as they can.
D)favor high-risk, high-return projects even if they have negative NPV, refuse to invest in low-risk, low-return projects with positive NPVs, and delay the onset of bankruptcy as long as they can.

Question 28

The costs of financial distress depend on the

A)probability of financial distress.
B)probability of financial distress and corporate and personal tax rates.
C)probability of financial distress, corporate and personal tax rates, and the magnitude of costs encountered if financial distress occurs.
D)probability of financial distress and the magnitude of costs encountered if financial distress occurs.

Question 29

Compared to a firm with unlimited liability, the limited liability feature of common equity results in a

A)lower present value of the interest tax shield.
B)higher value to equityholders.
C)leveraged buyout mechanism.
D)higher value to debtholders.

Question 30

Suppose that a company can direct $1 to either debt interest or to capital gains for equity investors.The capital gains tax rate is 15 percent.Which investor would not care how the money is channeled? (The marginal corporate tax rate is 35 percent.)

A)Investors paying zero personal tax
B)Investors paying a personal tax rate of 53 percent
C)Investors paying a personal tax rate of 17.5 percent
D)Investors paying a personal tax rate of 45 percent

Question 31

The indirect costs of bankruptcy are borne principally by

A)bondholders.
B)stockholders.
C)managers.
D)the federal government.

Question 32

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

A)no action by debtholders since these are equityholder concerns.
B)positive agency costs, as bondholders act on various restrictions and covenants, which will diminish firm value.
C)investments of the same risk class that the firm is in.
D)no action by debtholders since these are equityholder concerns and investments of the same risk class that the firm is in.

Question 33

Although the use of debt provides tax benefits to the firm, debt also puts pressure on the firm to

A)meet interest and principal payments, which if not met can put the company into financial distress.
B)make dividend payments, which if not met can put the company into financial distress.
C)make dividend payments, which if not met can put the company into financial distress; and to meet both interest and dividend payments, which when met increase the firm cash flow.
D)meet both interest and dividend payments, which when met increase the firm cash flow; and to meet increased tax payments, thereby increasing firm value.

Question 34

When faced with financial distress, managers of firms acting on behalf of their shareholders' interests will tend to

A)issue large quantities of low-quality debt versus low quantities of high-quality debt.
B)favor paying high dividends to shareholders.
C)delay the onset of bankruptcy as long as they can.
D)issue large quantities of low-quality debt versus low quantities of high-quality debt, favor paying high dividends to shareholders, and delay the onset of bankruptcy as long as they can.

Question 35

The MM theory with taxes implies that firms should issue maximum debt.In practice, this is not true because

A)debt is more risky than equity.
B)bankruptcy and its attendant costs are a disadvantage to debt.
C)the payment of personal taxes may offset the tax benefit of debt.
D)bankruptcy and its attendant costs are a disadvantage to debt, and the payment of personal taxes may offset the tax benefit of debt.

Question 36

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

A)the firm always choosing projects with positive NPVs.
B)stockholders turning down low-risk, low-return but positive NPV projects.
C)the firm declaring and paying high-cash dividends.
D)stockholders turning down low-risk, low-return but positive NPV projects, and the firm declaring and paying high-cash dividends.

Question 37

What are some of the possible consequences of financial distress?

A)Bondholders, who face the prospect of getting only part of their money back, will likely want the company to take additional risks.
B)Equity investors would like the company to cut its dividend payments to conserve cash.
C)Equity investors would like the firm to shift toward riskier lines of business.
D)Bondholders, who face the prospect of getting only part of their money back, will likely want the company to take additional risks; and equity investors would like the company to cut its dividend payments to conserve cash.

Question 38

Which of the following entities likely has the highest cost of financial distress?

A)A pharmaceuticals development company
B)A downtown bayfront hotel
C)A yacht leasing company
D)A real estate investment trust

Question 39

According to the trade-off theory of capital structure,

A)optimal capital structure occurs when the present value of tax savings on account of additional borrowing just offsets the increase in the present value of costs of distress.
B)optimal capital structure occurs when the stockholders' right to default is balanced by the bondholders' right to get interest and principal payments.
C)optimal capital structure occurs when the benefits of limited liability is just offset by the value of the firm's lawyers' claims.
D)None of the options are correct.

Question 40

Which of the following statement(s) regarding financial distress is (are) true?

A)Firms in financial distress always end up in bankruptcy.
B)Firms can postpone bankruptcy for many years.
C)Firms can postpone bankruptcy for many years, and, ultimately, the firm may recover from financial distress and avoid bankruptcy altogether.
D)Ultimately, the firm may recover from financial distress and avoid bankruptcy altogether.

Question 41

The value of a levered firm, given permanent debt level D, is
Value of levered firm = Value of unlevered firm + (T_C)(D).This assumes zero costs of financial distress.

Question 42

The trade-off theory of capital structure predicts that

A)unprofitable firms should borrow more than profitable ones.
B)safe firms should borrow more than risky ones.
C)rapidly growing firms should borrow more than mature firms.
D)increasing leverage increases firm value, especially at high debt ratios.

Question 43

Financial distress always results in bankruptcy.

Question 44

The existence of personal taxes on interest income and equity income will always increase the advantage of debt to a firm.

Question 45

When (1 - T_p) = (1 - T_pE)(1 - T_c), the impact of corporate and personal taxes makes the debt policy decision less significant.

Question 46

Financial distress occurs when promises to creditors are not honored or honored with great difficulty.

Question 47

When the costs of financial distress are included, the value of a levered firm is given by Value of levered firm = Value of unlevered firm + PV (tax shield) - PV (costs of financial distress).

Question 48

The right to default is valuable to shareholders.

Question 49

Financial slack includes

A)cash.
B)ready access to debt markets or bank loans.
C)readily salable real assets.
D)cash, marketable securities, readily salable real assets, and ready access to debt markets or bank loans.

Question 50

The pecking order theory of capital structure predicts that

A)if two firms are equally profitable, the more rapidly growing firm will end up borrowing more, other things equal.
B)firms prefer equity to debt financing.
C)firms prefer financing by debt versus internally generated cash.
D)high-risk firms will end up borrowing more.

Question 51

Under the trade-off theory, how will a government loan guarantee impact financing?

A)Prefer to issue debt
B)Prefer to issue stock
C)Prefer internal money
D)No impact occurs.

Question 52

The pecking order theory of capital structure implies that

A)high-risk firms will end up borrowing more.
B)firms prefer internal finance.
C)firms prefer internal finance and firms prefer debt to equity when external financing is required.
D)firms prefer debt to equity when external financing is required.

Question 53

Always use the average corporate tax rate to calculate the interest tax shields for firms.

Question 54

According to the trade-off theory, more profitable firms should have more debt and thus higher debt ratios on average.

Question 55

According to Rajan and Zingales, debt ratios of individual companies depend on

A)size: Large firms have higher debt ratios; and tangible assets: Firms with high ratios of fixed assets to total assets have higher debt ratios.
B)size: Large firms have higher debt ratios; tangible assets: Firms with high ratios of fixed assets to total assets have higher debt ratios; and profitability: More profitable firms have lower debt ratios.
C)size: Large firms have higher debt ratios; tangible assets: Firms with high ratios of fixed assets to total assets have higher debt ratios; profitability: More profitable firms have lower debt ratios; and market to book: Firms with higher ratios of market-to-book value have lower debt ratios.
D)size: Large firms have higher debt ratios; tangible assets: Firms with high ratios of fixed assets to total assets have higher debt ratios; profitability: More profitable firms have lower debt ratios; market to book: Firms with higher ratios of market-to-book value have lower debt ratios; and market structure: Firms with monopoly power have higher debt ratios.

Question 56

MM's Proposition I corrected for corporate taxes states that Value of levered firm = Value of unlevered firm + PV tax shield.

Question 57

Inclusion of restrictions in a bond contract leads to

A)higher agency costs.
B)higher bankruptcy costs.
C)higher interest costs.
D)lower agency costs.

Question 58

Risk shifting, refusing to contribute equity, and playing for time are some of the consequences of firms facing bankruptcy.

Question 59

The present value of the interest tax shield is the same regardless of whether the firm plans to borrow permanently or temporarily.

Question 60

What signal is sent to the market when a firm decides to issue new stock to raise capital?

A)Bond markets are overpriced.
B)Bond markets are underpriced.
C)Stock price is too low.
D)Stock price is too high.

Question 61

Explain the impact of government loan guarantees on corporate financing.

Question 62

The pecking order theory implies that firms prefer internal to external financing.

Question 63

What is the relative tax advantage of debt when corporate and personal taxes are considered?

Question 64

Briefly explain the trade-off theory of capital structure.

Question 65

A firm nearing bankruptcy has an incentive to issue more high-risk debt.

Question 66

Discuss the 1995 results of Rajan and Zingales from the trade-off theory perspective.

Question 67

Discuss the basic idea behind Miller's arguments about debt and taxes.

Question 68

Discuss some examples of conflicts of interest that may arise between bondholders and stockholders when a firm is in financial distress.

Question 69

Briefly explain how interest tax shields contribute to the value of stockholders' equity.

Question 70

State Modigliani-Miller's Proposition I, corrected to include corporate income taxes.

Question 71

Explain the pecking order theory of capital structure.

Question 72

The existing tax code encourages a preference for equity over debt in corporate financing.

Question 73

How is Modigliani-Miller's Proposition I modified when taxes and financial distress costs are considered?

Question 74

Briefly discuss bankruptcy costs.