Question 1

Inclusion of restrictions in the bond contract leads to:

Accepted Answer

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Question 2

The trade-off theory of capital structure predicts that:

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Question 3

The right to default is valuable for the stockholders of firms.

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The answer of The right to default is valuable for...

Question 4

According to Rajan and Zingales study, debt ratios of individual companies depend on: 
I. Size: Large firms have higher debt ratios.
II. Tangible assets: Firms with high ratios of fixed assets to total assets have higher debt ratios.
III. Profitability: More profitable firms have lower debt ratios.
IV. Market to book: Firms with higher ratios of market-to-book value have lower debt ratios. 
V. Market structure: Firms with monopoly power have higher debt ratios.

Accepted Answer

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Question 5

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

Accepted Answer

According to the trade-off theory, more profitable firms can afford to take more financial risk and therefore should have higher debt ratios. By leveraging debt financing, these firms can increase their returns to shareholders and maximize value. However, excessive debt can also increase the risk of financial distress or bankruptcy, so firms must balance the benefits of debt with the costs of financial distress.

Question 6

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

Accepted Answer

These are indeed some of the consequences that firms facing bankruptcy may exhibit. Risk shifting refers to a situation where a firm takes more risks in order to try and generate higher returns to mitigate losses, while refusing to contribute equity means that the firm may resist putting in more of its own funds to address its financial difficulties. Playing for time means that the firm may delay decisions or actions in the hope that its financial situation will improve on its own.

Question 7

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

Accepted Answer

The present value of the interest tax shield depends on whether the firm plans to borrow permanently or temporarily because the value is influenced by the duration and amount of debt, as well as the firm's tax rate. Permanent borrowing typically results in a larger and more predictable interest tax shield compared to temporary borrowing.

Question 8

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

Accepted Answer

Personal taxes on interest income are higher than taxes on equity income, thereby creating an advantage of equity financing over debt financing. When personal taxes on equity income rise, the advantage of debt financing decreases even more.

Question 9

Financial slack includes: I) Cash
II) Marketable securities
III) Readily salable real assets
IV) Ready access to debt markets or bank loans

Accepted Answer

Financial slack includes all four components listed in the options: cash, marketable securities, readily saleable real assets, and access to debt markets or bank loans. All of these components help a company maintain financial flexibility and ability to respond to unexpected events or opportunities.

Question 10

The pecking order theory of capital structure predicts that:

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Question 11

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

Accepted Answer

The Pecking order theory suggests that firms have a preference for internal financing (retained earnings) over external financing (debt and equity) due to information asymmetry and agency costs.

Question 12

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

Accepted Answer

Financial distress is a situation that arises when an individual or company is unable to meet its financial obligations to creditors. The failure to honor these promises can lead to a range of consequences, including default, bankruptcy, and other forms of financial instability.

Question 13

When (1 - Tp) = (1 - TpE)(1 - TC), corporate and personal taxes cancel to make debt policy irrelevant.

Accepted Answer

When (1 - Tp) = (1 - TpE)(1 - TC), corporate and personal taxes cancel each other out, making debt policy irrelevant. This is because the tax shield provided by debt is offset by the increased personal taxes due to the interest payments on that debt. Therefore, the value of the firm is independent of its capital structure, and the company can choose any combination of debt and equity without affecting its overall value.

Question 14

MM's Proposition I corrected for corporate taxes states that: Value of levered firm = Value (all equity financed) + PV tax shield.

Accepted Answer

MM's Proposition I with corporate taxes states that the value of a levered firm is equal to the value of an all-equity financed firm plus the present value of the tax shield, which results from deducting interest payments from taxable income.

Question 15

The value of a levered firm is given by:
Value of levered firm = Value (all equity financed) + (TC) * (D) This assumes that the debt is perpetual debt.

Accepted Answer

This is the famous Modigliani-Miller theorem, which states that the value of a levered firm is equal to the value of an all-equity financed firm plus the tax shield from debt. This assumes that the debt is perpetual, meaning it never matures and can be rolled-over indefinitely.

Question 16

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

Accepted Answer

When a firm decides to issue new stock to raise capital, it is an indication that the company's management feels that the stock is overvalued, and they want to take advantage of the high market price to raise capital. Therefore, the correct choice is D as the stock price is too high.

Question 17

The pecking order theory of capital structure implies that: 
I. Risky firms will end up borrowing more
II. Firms prefer internal finance
III. Firms prefer debt to equity when external financing is required

Accepted Answer

The pecking order theory of capital structure suggests that firms prefer internal financing first (II) and will take on debt before equity (III) when external financing is required. Risky firms may indeed end up borrowing more (I), but this is not necessarily implied by pecking order theory. Therefore, options II and III are both correct, giving us choice (C) as the best answer.

Question 18

When cost of financial distress is included, the value of a levered firm is given by: Value of levered firm = Value (all equity financed) + PV (tax shield) - PV (costs of financial distress).

Accepted Answer

This is the correct formula for calculating the value of a levered firm when taking into account the costs of financial distress. The value of the firm is equal to the value if it were all equity financed, plus the present value of the tax shield from debt, minus the present value of the costs of financial distress.

Question 19

Financial distress always results in bankruptcy.

Accepted Answer

Financial distress does not always result in bankruptcy. There are other options such as debt restructuring, negotiations with creditors, or selling assets to pay off debt. Bankruptcy is a last resort option.

Question 20

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

Accepted Answer

The average corporate tax rate may not accurately reflect the actual tax rate of a specific firm. It is best to use the specific firm's marginal tax rate to calculate the tax shields.

Quiz 14: How Much Should a Corporation Borrow