Question 1

Which of the following lists presents the order of financing from most preferred to least preferred according to the pecking order theory?

Accepted Answer

According to the pecking order theory, firms prefer to finance investments first with internally generated funds, then with debt, and finally with equity as a last resort. Therefore, the correct order is: internally generated funds, debt issue, stock issue. Option B presents this order correctly.

Question 2

What can be promised by loan covenants? What cannot be ensured by loan covenants?

Accepted Answer

The answer of What can be promised by loan covenants?...

Question 3

In a world with corporate taxes but no possibility of financial distress,the value of the firm is maximized when the:

Accepted Answer

In a world with corporate taxes but no possibility of financial distress, the value of the firm is maximized when the firm uses no equity in its capital structure. This is because debt interest payments are tax-deductible, which reduces the firm's taxable income and thus its tax liability, increasing the overall value of the firm. This concept is derived from the Modigliani-Miller theorem on capital structure, which, under these conditions, suggests that a firm can reduce its overall cost of capital and increase value by financing entirely with debt.

Question 4

Determine the expected return on equity for a firm with a WACC of 12%,$500,000 in 9% debt,and $800,000 in equity.Both debt and equity are shown at market values,and the firm pays no taxes.How can the expected return on equity be reduced?

Accepted Answer

The answer of Determine the expected return on equity for...

Question 5

According to pecking order theory,managers will often choose to finance with:

Accepted Answer

Pecking order theory suggests that managers prefer financing with internal funds (such as retained earnings) first, followed by debt and then equity. The reason for this preference is that issuing new equity can lead to a decrease in the share price, which is unfavorable for existing shareholders. On the other hand, bankruptcy costs associated with high levels of debt financing may also be a concern. Therefore, managers may opt for debt financing before considering new equity issuance.

Question 6

A firm's business risk depends upon:

Accepted Answer

Business risk is the risk associated with the firm's assets and operations. This includes the nature of the industry in which the firm operates, competition, technology, legal and regulatory environment, and other factors that can impact the profitability and sustainability of the firm's operations. While factors such as leverage and financial distress can also impact a firm's risk profile, they are not components of the firm's inherent business risk.

Question 7

Show how leverage increases financial risk by calculating the EPS and return on shares for a firm with $1 million in 10% debt.The firm also has 50,000 shares outstanding that sell for $40 each.Three states of the economy are possible: a slump under which the firm would have operating income of $150,000,a normal state under which the firm will earn $420,000,and a boom under which the firm will earn $600,000.The firm pays no taxes.

Accepted Answer

The answer of Show how leverage increases financial risk by...

Question 8

What is the goal of the capital structure decision? What is the financial manager trying to do?

Accepted Answer

The answer of What is the goal of the capital...

Question 9

Which of the following is a safe assumption for a firm in which the PV of the tax shield is approximately equal to the costs of financial distress?

Accepted Answer

The answer of Which of the following is a safe...

Question 10

Equity,Inc.is currently an all-equity-financed firm.It has 10,000 shares outstanding that sell for $20 each.The firm has an operating income of $30,000 and pays no taxes.The firm contemplates a restructuring that would issue $50,000 in 8% debt which will be used to repurchase stock.Show the value of the firm,EPS,and rate of return on the stock before and after the proposed restructuring.What changed?

Accepted Answer

The answer of Equity,Inc.is currently an all-equity-financed firm.It has 10,000...

Question 11

When large firms file for bankruptcy,they usually do so under an arrangement called:

Accepted Answer

Chapter 11 bankruptcy is typically used by large businesses to reorganize and pay off their debts while still operating. Chapter 9 applies to municipalities, Chapter 13 is for individuals with regular income, and Chapter 14 does not exist in the bankruptcy code.

Question 12

According to the trade-off theory,the capital structure is a trade-off between:

Accepted Answer

The trade-off theory suggests that a company's optimal capital structure is a balance or"trade-off" between tax savings from debt financing and the financial distress costs associated with high levels of debt. As a result, option C (tax savings and financial distress costs) is the correct choice. Option A is incorrect because it does not accurately reflect the trade-off theory. Option B is incorrect because the trade-off is not between high and low target debt ratios, but rather between the benefits and costs of debt financing. Option D is incorrect because it is not a comprehensive reflection of the trade-off theory.

Question 13

Firms facing financial distress may pass up positive-NPV projects rather than commit new equity because:

Accepted Answer

Firms facing financial distress may pass up positive-NPV projects rather than commit new equity because the benefits may be shared with the bondholders. As a result, higher cash flows from the new project may not flow entirely to equity holders, and this will inevitably reduce the value of the equity.

Question 14

If a firm's expected return on equity equals its expected return on assets,then the:

Accepted Answer

If a firm's expected return on equity equals its expected return on assets, it means that there is no leverage involved, i.e., the firm has no debt in its capital structure. Therefore, option D is the correct answer. Options A, B, and C are irrelevant in this case.

Question 15

Costs of distress are greater when a large amount of __________ affect(s)the prosperity of the firm.

Accepted Answer

Intangible assets are harder to liquidate or value in distress situations, making the costs of distress higher for firms with a large amount of intangible assets.

Question 16

If the present value of the tax shield equals the present value of the costs of financial distress,then the:

Accepted Answer

The answer of If the present value of the tax...

Question 17

When corporate taxes and the cost of financial distress are taken into consideration,the market value of a firm equals the value if all-equity-financed _____ the PV of the tax shield _____ the costs of financial distress.

Accepted Answer

When a firm is all-equity financed, there is no tax shield available from debt. Therefore, adding debt will increase the PV of the tax shield, which will increase the overall value of the firm. However, adding debt also increases the risk of financial distress, which will decrease the overall value of the firm. The net effect is that the value of the firm will increase if the PV of the tax shield is greater than the costs of financial distress. Therefore, the market value of a firm equals the value if all-equity-financed plus the PV of the tax shield minus the costs of financial distress.

Question 18

The optimal capital structure is met when:

Accepted Answer

The optimal capital structure is met when the tax savings from additional leverage are offset by the costs of distress. This means that the benefits of increased debt (such as the interest tax shield) are balanced by the potential costs of financial distress (such as bankruptcy costs, legal fees, and damage to the company's reputation). The goal is to find the right balance between debt and equity financing to maximize the value of the firm. Option A is incorrect as financial distress costs would not decrease with additional borrowing. Option B is incomplete and incomplete information is not provided to verify the correctness of the statement. Option D is incorrect as the value of an all-equity-financed firm is less than the value of a leveraged firm.

Question 19

Explain the pecking order theory of capital structure.How will this affect the "optimal" capital structure for a firm?

Accepted Answer

The answer of Explain the pecking order theory of capital...

Question 20

Equity,Inc.is currently an all-equity-financed firm.It has 10,000 shares outstanding that sell for $20 each.The firm has an operating income of $30,000 and pays no taxes.The firm contemplates a restructuring that would issue $50,000 in 8% debt which will be used to repurchase stock.Assuming that individuals have the same borrowing opportunities as corporations,explain how an investor can undo the leverage that is proposed by Equity,Inc.Under these conditions,what is the value of restructuring to a firm?

Accepted Answer