Deck 18: More Market Imperfections Influencing Capital Structure

Question 1

Assume that a corporation pays taxes on earnings at a flat rate of 40%. If the firm earns $800,000 in operating profit and pays $50,000 in interest expense and $100,000 in dividends to
Its shareholders, what is its tax liability?

A)$260,000
B)$340,000
C)$315,000
D)$300,000

Answer 1

$300,000

Question 2

Assume all investors have a choice between investing in equity that will offer a 10% return in the form of capital gains or investing in debt that will offer a 13% return in the form of interest
Income. Investor A pays taxes at the rate of 35%, and Investor B pays taxes at the rate of 20%
On ordinary income. Both pay taxes at the rate of 15% on capital gain income. Which type of
Investment should each investor make?

A)Investor A should invest in equity, which will offer him an 8.5% after-tax return. Investor B should invest in debt for an after-tax return of 9.75%.
B)Both should invest in equity since it is taxed at a lower rate.
C)Both should invest in the debt. After tax, this will offer Investor A a return of 8.45%, and Investor B will earn 9.75%. If they invested in equity, Investor A will earn only 5.525%
After taxes, and Investor B only 6.375%.
D)Both should invest in the debt. After tax, this will offer both investors an 11% return. If they invested in equity, Investor A will earn only 6.5% after taxes, and Investor B only
7.5%.

Answer 2

Investor A should invest in equity, which will offer him an 8.5% after-tax return. Investor B should invest in debt for an after-tax return of 9.75%.

Question 3

Which of the following would be considered to be an indirect bankruptcy cost?

A)Managers select projects that have the shortest payback period, so that they get cash back quicker.
B)The firm's suppliers will ship only COD or CBD.
C)Fearing that they will not be able to obtain parts for the firm's products, customers buy from the firm's competitors.
D)All of the above are indirect bankruptcy costs.

Answer 3

All of the above are indirect bankruptcy costs.

Question 4

Assume a firm is financed with 50% safe debt at a cost of 5%, and 50% equity. The firm has a market value of $20 billion and promises a 12% ($2.4 billion)return. In a world with no taxes,
What is the firm's price/earnings ratio? Round your answer to the nearest hundredth.

A)10.53
B)8.33
C)7.92
D)14.29

Question 5

Which of the following is a valid reason for a firm not to use as much debt as it can raise?

A)The use of more debt is expected to result in a lower price/earnings ratio.
B)The use of more debt is expected to result in an increase in the firm's cost of capital when everything is considered.
C)More debt will increase the firm's riskiness.
D)All of the above are valid reasons for a firm to use less debt than might be available.

Question 6

A corporation pays taxes at the flat rate of 40% and has operating profit of $1 million. It pays interest of $300,000 and dividends of $200,000 to its investors. All investors share the same tax
Rates: 35% on interest income and 15% on dividend income. What are the total taxes collected
By the government?

A)$415,000
B)$335,000
C)$135,000
D)$535,000

Question 7

Assume all investors have a choice between investing in equity that will offer a 10% return in the form of capital gains or investing in debt that will offer a 14% return in the form of interest
Income. Investor A pays taxes at the rate of 35%, and Investor B pays taxes at the rate of 20%
On ordinary income. Both pay taxes at the rate of 15% on capital gain income. Which type of
Investment should each investor make?

A)Investor A should invest in equity, which will offer him an 8.5% after-tax return. Investor B should invest in debt for an after-tax return of 10.5%.
B)Both should invest in equity since it is taxed at a lower rate.
C)Both should invest in the debt. After tax, this will offer Investor A a return of 9.1%, and Investor B will earn 10.5%. If they invested in equity, each would earn only 8.5% after
Taxes.
D)None of the above is correct.

Question 8

Which of the following types of firms is likely to suffer the most in the event of bankruptcy?

A)a large retail store
B)a computer manufacturer
C)a railroad
D)an electric utility company

Question 9

Does the empirical evidence suggest that management should invest any time and
energy into minimizing the total taxes paid?

Question 10

An individual earned $75,000 of taxable income from wages, $10,000 of interest income, and $12,000 of dividend income. Her tax rate is 30% on ordinary income and 15% on dividend
Income. How much does she owe in taxes?

A)$27,300
B)$25,800
C)$24,000
D)none of the above

Question 11

Which of the following statements is true?

A)Large firms that have a lot of cash should be more equity-financed.
B)Investors who are tax-exempt should invest more in bonds.
C)Small-growth firms should use more debt financing.
D)Investors in high marginal tax brackets should invest more in bonds.

Question 12

The legal filing that allows a firm in bankruptcy the opportunity to reorganize, and thus avoid having to liquidate its assets,is called a

A)Chapter 11.
B)Chapter 7.
C)Chapter 1.
D)Chapter 15.

Question 13

The current academic consensus regarding the relevance of bankruptcy costs on capital structure decisions is that

A)expected bankruptcy costs for large, healthy firms are small and probably can be ignored when determining these firms' capital structures.
B)the relevance of bankruptcy costs to a firm's capital structure decision is directly proportional to the number of times the firm has filed for bankruptcy in the past.
C)only the direct costs associated with bankruptcy need be considered since the indirect costs are minor by comparison and are difficult to quantify.
D)None of the above is true.

Question 14

The most tax-advantaged form of income for investors is

A)dividend income.
B)long-term capital gain income.
C)interest income on corporate debt.
D)Both A and C are equal in their tax advantages.

Question 15

A corporation pays taxes at the flat rate of 40% and has operating profit of $1 million. It pays interest of $200,000 and dividends of $300,000 to its investors. All investors share the same tax
Rates: 35% on interest income and 15% on dividend income. What are the total taxes collected
By the government?

A)$315,000
B)$435,000
C)$515,000
D)$200,115

Question 16

In Fictitious Nation, both dividend and interest income are taxed at the same rate. A new tax law is passed that increases both corporate and personal tax rates. What effect will this likely
Have on the capital structure decision of the nation's firms?

A)Since both debt and equity income are taxed at the same rate, the optimal capital structure for most firms will be 50% debt and 50% equity when personal taxes are taken into
Consideration.
B)Firms will use more debt in their capital structure.
C)Firms will use more equity in their capital structure.
D)There will be no change in the capital structure of the nation's firms since both corporate and personal tax rates have increased.

Question 17

All else equal, what would you expect to happen to the cost of equity capital for firms
if the Bush dividend tax cut of 2003 is reversed? (That is, if dividends are once again
taxed at the marginal tax rate of investors.)How might this affect the optimal capital
structure of firms, if at all? Explain.

Question 18

Assume that a law is passed that allows investors to exclude 50% of interest income earned on corporate bond investments from federal taxation. All else equal, which of the following is a
Likely result?

A)The market values of corporate bonds will increase.
B)The overall market value of corporate equity will increase.
C)The cost of capital for all corporations will increase.
D)All of the above are likely to occur.

Question 19

All else equal, which of the following statements is (are)true?

A)The more debt a firm uses, the riskier its equity becomes, which, in turn, causes the value of both the debt and the equity to decrease.
B)The lower the cost of capital of a firm, the higher will be its market value.
C)The higher the P/E ratio, the higher the value of the firm will be.
D)All of the above are true statements.

Question 20

All else equal, which of the following statements is true from a tax standpoint, given current U.S. tax laws?

A)Although a firm is able to deduct both interest expense and dividend distributions in determining taxable income, investors prefer to receive dividend income since it is taxed at
A lower rate.
B)Corporate tax liability is decreased with the use of debt, but interest income is not tax-advantaged to the investors.
C)The use of debt can result in lower taxes for the corporation, and interest income is taxed at preferred rates at the investor level.
D)The tax-preferred financing method is the use of retained earnings since a firm does not pay any taxes on reinvested earnings, and capital gains are not taxed at the investor level
Until they are realized.

Question 21

Uncontrolled free cash flow and agency concerns may be a sign that

A)managers own a disproportionate share of the firm.
B)managers are underinvesting the firm's cash flow.
C)a firm is using too much debt financing.
D)a firm is using too much equity financing.

Question 22

How can too much free cash flow be problematic? Explain how a firm might establish
a dividend policy that could minimize this concern.

Question 23

Under what scenario will having debt in the capital structure minimize the "reluctance
to liquidate" problem? How?

Question 24

Which of the following statements is true?

A)When a firm issues bonds of equal or higher priority to its existing debt, the value of both the existing bonds and the value of the equity will decrease.
B)When a firm can issue bonds of equal or higher priority than its existing bonds, the value of the firm is decreased due to the higher cost of debt capital.
C)Although the value of a firm is unchanged if it can issue debt of equal or greater priority to its existing debt, its cost of debt capital will be higher.
D)Both A and C are true.

Question 25

Rent seeking can be a problem if a firm has

A)too much debt.
B)too much cash.
C)managers who are also majority owners of the firm.
D)all of the above.

Question 26

A firm is worth $50 or $180 with equal probability. Management wants to issue a bond that has a face value of $60. The cost of capital for all securities is 12%. If the potential bondholders
Fear that the firm will issue new debt with a face value of $40 that has the same priority as the
$60 debt being sold today, what will they require as a return on their investment?

A)22.2%
B)44.9%
C)49.3%
D)36.9%

Question 27

A firm has a 40% chance of producing $90 in cash flows next year, and a 60% chance of producing $200 in cash flows. Assume risk neutrality and a cost of capital of 9%.
Refer to the information above. What is the value of the firm if debt has a face value of $50?

A)$156.00
B)$110.09
C)$143.12
D)$120.00

Question 28

A firm is worth $50 or $180 with equal probability and is financed with debt that has a face value of $60. It is considering a new project that is equally likely to be worth -$50 or +$40. The cost of capital is 12% for all securities.
Refer to the information above. What will the bondholder's require as a return on their investment if they fear expropriation?

A)12.0%
B)22.2%
C)36.9%
D)33.3%

Question 29

A firm has a 40% chance of producing $90 in cash flows next year, and a 60% chance of producing $200 in cash flows. Assume risk neutrality and a cost of capital of 9%.
Refer to the information above. Your firm has debt with a face value of $100. Deadweight financial distress costs are $25. What is your firm's cost of debt capital?

A)13.5%
B)21.7%
C)16.3%
D)none of the above

Question 30

A firm is worth $50 or $180 with equal probability and is financed with debt that has a face value of
$60. The cost of capital for all securities is 12%. If the firm issues new debt with a face value of
$40 that has the same priority as the $60 debt being sold today, by how much will the equity
Holders wealth increase or decrease?

A)The wealth of the equity holders will decrease $17.86.
B)The wealth of the equity holders will decrease $20.00
C)The wealth of the equity holders will increase $8.93.
D)The wealth of the equity holders will increase $35.71.

Question 31

A firm is worth $50 or $180 with equal probability and is financed with debt that has a face value of $60. It is considering a new project that is equally likely to be worth -$50 or +$40. The cost of capital is 12% for all securities.
Refer to the information above. What will happen to the value of the firm if the new project is undertaken?

A)The value will decrease by $4.46.
B)The value will decrease by $5.00.
C)The value will increase by $10.00.
D)The value will decrease by $8.93.

Question 32

Which of the following statements is true?

A)In order to maximize firm value, management should commit to take on no projects that could decrease the value of the existing debt.
B)Undertaking a negative NPV project may increase the value of a firm's equity while decreasing overall firm value.
C)Undertaking a positive NPV project will always increase the values of both the firm's debt and its equity.
D)In order to maximize firm value, management should undertake all projects that will maximize the value of its equity.

Question 33

A firm is worth $50 or $180 with equal probability and is financed with debt that has a face value of $60. It is considering a new project that is equally likely to be worth -$50 or +$40. The cost of capital is 12% for all securities.
Refer to the information above. Calculate the present values of the firm's debt and equity, assuming that the project is not undertaken.

A)Debt = $55.00; Equity = $60.00
B)Debt = $102.68; Equity = $75.89
C)Debt = $49.11; Equity = $53.57
D)Debt = $50.00; Equity = $54.55

Question 34

The management of an airline suffering from financial distress decides to put off its plans to remodel some of its planes' interiors in order to attract more business clientele since the
Additional expected cash flow generated would only go to pay off its bondholders. Instead,
Management uses the funds to repurchase some of its outstanding shares. This problem is
Know as

A)failure to maintain.
B)reluctance to liquidate.
C)underinvestment.
D)stakeholder holdup.

Question 35

Which of the following concerns would cause debt financing to be more attractive than equity financing?

A)the underinvestment problem
B)the excess free cash flow problem
C)the theft problem
D)both B and C

Question 36

A firm has a 40% chance of producing $90 in cash flows next year, and a 60% chance of producing $200 in cash flows. Assume risk neutrality and a cost of capital of 9%.
Refer to the information above. What is the value of the firm if debt has a face value of $100, and deadweight financial distress costs are $25?

A)$133.95
B)$143.12
C)$131.00
D)$146.00

Question 37

Which of the following should be considered a cost of debt?

A)deadweight costs
B)underinvestment
C)stakeholder holdup costs
D)both A and B

Question 38

A firm is worth $50 or $180 with equal probability and is financed with debt that has a face value of $60. It is considering a new project that is equally likely to be worth -$50 or +$40. The cost of capital is 12% for all securities.
Refer to the information above. Calculate the present values of the firm's debt and equity if the project is undertaken.

A)Debt = $45.00; Equity = $65.00
B)Debt = $40.91; Equity = $59.09
C)Debt = $40.18; Equity = $58.03
D)Debt = $26.79; Equity = $49.11

Question 39

Describe and briefly discuss the indirect costs associated with financial distress.

Question 40

A firm is worth $50 or $180 with equal probability and is financed with debt that has a face value of
$60. The cost of capital for all securities is 12%. If the firm issues new debt with a face value of
$40 that has the same priority as the $60 debt being sold today, what effect will it have on the
Value of the existing debt?

A)The value of the existing debt will increase, but the amount of risk shared by the new bondholders must be known in order to calculate the exact amount of the increase.
B)The value of the existing debt will decrease $8.93.
C)There will be no effect on the value of the existing debt.
D)The value of the existing debt will increase $26.79.

Question 41

If a firm uses less debt in its capital structure than is optimal, then

A)its investors will pay more in personal income taxes than is necessary.
B)the firm will pay more in corporate income taxes than is necessary.
C)there will be less free cash flow for managers to invest in positive NPV projects.
D)all of the above.

Question 42

Managerial overconfidence may alleviate which of the following concerns?

A)the underinvestment problem
B)the insider information problem
C)the negative NPV problem
D)the failure to liquidate problem

Question 43

The best method to use to value a firm under a given capital structure when numerous market imperfections (e.g., agency issues, personal taxes, and transaction costs)exist is the

A)weighted average cost of capital (WACC)method.
B)flow-to-equity method.
C)KISS method.
D)adjusted present value (APV)method.

Question 44

If a firm's optimal capital structure is relatively flat,

A)the cost of short-term financing and long-term financing will be roughly equal for the firm.
B)the firm should be using 50% debt and 50% equity financing.
C)a firm's management should not be concerned about small deviations of their debt ratio from its optimal level.
D)the firm's cost of capital will be minimized by using more equity financing.

Question 45

To what does the term "strip financing" refer?

A)the purchase of equal amounts of the debt and equity of a firm
B)zero-coupon U.S. government bonds
C)the issue of debt that can be converted to common stock
D)the issue of debt of equal priority over a number of consecutive years

Question 46

Which of the following statements is true?

A)If a firm has a project that management believes will be very successful, management is more likely to finance the project with debt financing than with new equity.
B)Issuing new equity is a positive signal to investors.
C)Issuing debt is a negative signal to investors.
D)If a firm has a project that management believes will be very successful, management is more likely to finance the project with equity than with debt.

Question 47

Which of the following statements about transaction costs is true?

A)The low transaction costs associated with issuing new equity mean that smaller firms are often 100% equity financed.
B)Transaction costs are small enough to be ignored when making a decision regarding capital structure.
C)Firms with lower credit ratings may face higher transaction costs than firms with good credit ratings.
D)Transaction costs cause debt financing to be favored over equity financing.

Question 48

A firm has a market value of $10 million, $1 million of which is debt. The equity beta is 0.9, and the firm's debt is considered to be risk-free. The firm pays taxes at the marginal rate of
40%. The equity risk premium is 4%, and the relevant risk-free rate is 6%. Calculate the firm's
WACC.

A)13.5%
B)9.2%
C)9.0%
D)none of the above

Question 49

How are the various market imperfections reflected when using the flow-to-equity
method of valuation?

Question 50

Which of the following statements is true?

A)When using CAPM to estimate a WACC, personal taxes are not deducted since the corporation must compensate investors for the extra tax obligations they incur.
B)When using CAPM to estimate a WACC, the expected return on the market portfolio should be the expected return on a stock market index (e.g., the 500 Index)when
Calculating the cost of equity capital, and it should be the expected return on a bond
Market index when calculating the cost of debt capital.
C)When calculating the WACC, the promised, after-tax return on debt should be used.
D)When using CAPM to estimate a WACC, you should use the relevant, after-tax risk-free rate and the after-tax expected return on the market, taking both corporate and personal
Tax rates into account.

Question 51

Which of the following concerns will cause equity financing to be favored over debt financing?

A)debt expropriation
B)agency conflicts
C)insider information
D)corporate income taxes

Question 52

What are the problems with using too little debt in the capital structure?

Question 53

A firm has a market value of $500 million, $200 million of which is debt. Its equity beta is 1.3, and the beta of the debt is 0.1. The firm pays taxes at the marginal rate of 35%. The expected
Return on the market is 10%, and the relevant risk-free rate is 5%. What is the firm's WACC?
Round your answer to the nearest tenth of a percent.

A)8.3%
B)9.1%
C)5.9%
D)12.4%

Question 54

Which of the following mechanisms can aid in reducing a firm's cost of capital, all else equal?

A)a bond covenant that restricts the amount of dividends a firm can pay
B)the use of convertible debt financing
C)a greater percentage of equity financing
D)both A and B

Question 55

True, False, or Uncertain: If the optimal capital structure of a firm is fairly flat,
management does not need to be concerned about small deviations in the firm's debt
ratio.

Question 56

What is the inside information problem? Explain how the inside information problem
might cause a publicly-traded firm to take on debt to the point of incurring financial
distress.

Question 57

The inside information problem might not result in a higher cost of equity if

A)investors are overly pessimistic.
B)investors are overly optimistic.
C)the firm's management is known to be overly optimistic.
D)the firm's management is known to be overly pessimistic.

Question 58

Which of the following is a firm likely to issue to finance its very best projects?

A)senior debt
B)junior debt
C)preferred stock
D)common equity

Question 59

What are two ways in which managers can exploit bondholders on behalf of its
shareholders? Explain briefly.

Question 60

How has the Sarbanes-Oxley Act affected transaction costs and, therefore, capital
structure decisions?

Question 61

How does a corporation's reputation affect financing costs and firm value? Explain.

Question 62

If interaction effects make it difficult for a firm to adjust its capital structure based on prevailing conditions, then

A)the firm should target a 50% debt/50% equity capital structure.
B)the firm should choose the capital structure that will minimize all transaction costs--both direct and indirect.
C)the firm should use as much debt financing as possible when it is financially healthy in order to benefit from lower corporate taxes.
D)the firm should use more equity financing than is necessarily optimal today in order to maintain financial flexibility.