Question 1

The tax savings of the firm derived from the deductibility of interest expense is called the:

Accepted Answer

The tax savings a firm realizes from the deductibility of interest expense is referred to as the Interest Tax Shield. This concept is based on the idea that interest expenses are deductible before taxes, which reduces the taxable income and thus the taxes a company needs to pay.

Question 2

The equity risk derived from a firm's operating activities is called _____ risk.

Accepted Answer

Business risk is associated with a firm's operating activities, reflecting the risk that the company will not be able to generate sufficient revenue to cover its operational costs.

Question 3

According to M&M Proposition I with taxes, the interest tax shield:

Accepted Answer

M&M Proposition I with taxes posits that the value of a leveraged firm is equal to the value of an unleveraged firm plus the present value of the tax shields due to debt. Therefore, the interest tax shield directly increases the value of a firm by reducing the amount of taxes it pays, as interest payments are tax-deductible.

Question 4

The capital structure of a firm refers to the firm's:

Accepted Answer

The capital structure of a firm refers to how a firm finances its overall operations and growth by using different sources of funds, which is best represented by the firm's debt-equity ratio. This ratio indicates the relative proportions of debt and equity used to finance the firm's assets.

Question 5

Which of the following statements is correct?

Accepted Answer

Homemade leverage refers to the use of personal borrowing or lending by an investor to adjust their own exposure to financial leverage, effectively replicating the leverage of a firm.

Question 6

Indirect bankruptcy costs:

Accepted Answer

Indirect bankruptcy costs refer to the costs a firm incurs in an attempt to stave off bankruptcy, such as lost sales, suppliers demanding unfavorable payment terms, and the cost of management time spent on avoiding bankruptcy, rather than on productive activities. These costs are not the direct legal and accounting fees associated with the bankruptcy process itself, but rather the broader, more diffuse costs associated with the deterioration of the firm's financial health.

Question 7

A firm that has negative net worth is said to be:

Accepted Answer

A firm with negative net worth is experiencing accounting insolvency, meaning its liabilities exceed its assets on the balance sheet.

Question 8

Which of the following does not correctly rank the priority of claims of the parties to a corporate bankruptcy? (Rank from strongest to weakest.)

Accepted Answer

Government tax claims have a higher priority than both preferred stockholders and unsecured creditors in a corporate bankruptcy.

Question 9

Individual investors who lend out part of their personal funds are in fact:

Accepted Answer

Individual investors who lend out part of their personal funds are in fact leveraging their investments.

Question 10

Of the following, all are conclusions that can be drawn from the capital structure puzzle EXCEPT:

Accepted Answer

The capital structure puzzle is a term used to describe the complexities and uncertainties surrounding the best choice of capital structure for a firm. The statement that a firm can precisely identify its optimal capital structure (A) is not a conclusion that can be drawn from the capital structure puzzle. In fact, the puzzle suggests that there is no clear, one-size-fits-all answer to what the optimal capital structure is, as it can be influenced by many factors such as taxes, bankruptcy costs, agency costs, and asymmetric information.

Question 11

The equity risk derived from the firm's operating activities is called ____________ risk.

Accepted Answer

Business risk is the equity risk that comes from the firm's operating activities, reflecting the uncertainty associated with the firm's earnings due to factors like demand for its products, pricing competition, input costs, and operational efficiency.

Question 12

Jageman Athletic Apparel has a debt-equity ratio of.4 and earnings before interest and taxes (EBIT) of $265,000. The break-even level of EBIT is $338,000. Based on this information, you know the:

Accepted Answer

The break-even level of EBIT ($338,000) is higher than the current EBIT ($265,000), indicating that the firm is not covering its fixed costs, including interest on debt. This suggests that the firm's debt is a disadvantage because it increases the firm's fixed costs, making it harder to break even.

Question 13

Which of the following is true regarding bankruptcy?

Accepted Answer

In a prepackaged bankruptcy (prepack), creditors agree to a reorganization plan before the bankruptcy filing, which helps streamline the process and can lead to a quicker resolution. This allows the company to restructure its debts with the agreement of its creditors, making the bankruptcy process more efficient.

Question 14

Assume there are no corporate or personal taxes. According to M&M Proposition:

Accepted Answer

DM&M Proposition II states that the cost of equity increases as a firm increases its use of debt financing due to the higher financial risk assumed by equity holders. It also asserts that the cost of equity is influenced by the firm's business risk, which is independent of its financial risk, indicating that while financial leverage affects the required return on equity, it does not alter the firm's inherent business risk.

Question 15

The equity risk derived from a firm's capital structure policy is called _____ risk.

Accepted Answer

Financial risk is specifically associated with the way a company finances its operations, primarily through debt or equity. This risk arises from the potential that a company will not be able to meet its financial obligations, which is directly related to its capital structure policy.

Question 16

The interest tax shield has more value when the amount of debt is _____ and the tax rate is _____.

Accepted Answer

The interest tax shield refers to the tax saving achieved by deducting interest payments before calculating taxable income, which reduces the total tax payable. Its value increases with both the amount of debt (since more interest is deductible) and the tax rate (since the savings from each dollar of interest deducted are greater).

Question 17

All else the same, the financial leverage of a firm will _________________.

Accepted Answer

Financial leverage decreases as the firm's retained earnings grow because retained earnings increase equity, reducing the debt-to-equity ratio.

Question 18

The static theory of capital structure states that firms borrow up to the point where the tax benefit of one additional dollar of debt is equal to the marginal cost of:

Accepted Answer

The static theory of capital structure, also known as the trade-off theory, suggests that firms balance the tax benefits of debt financing against the costs of financial distress. This theory posits that there is an optimal level of debt where the marginal tax shield benefits of borrowing one more dollar are exactly offset by the increased marginal costs of financial distress associated with that additional dollar of debt.

Question 19

Which one of the following statements concerning financial leverage is correct in a world without taxes?

Accepted Answer

M&M Proposition I, proposed by Modigliani and Miller, states that in a world without taxes, transaction costs, or other market imperfections, the value of a leveraged firm is the same as the value of an unleveraged firm. This implies that financial leverage does not affect the overall value of the firm, making option E correct.

Question 20

The equity risk derived from the firm's capital structure policy is called ___________ risk.

Accepted Answer

Financial risk is specifically associated with the way a company finances its operations, primarily through debt or equity, which directly relates to the firm's capital structure policy.

Quiz 16: Financial Leverage and Capital Structure Policy