Deck 17: Capital Structure: Limits to the Use of Debt

Question 1

Conflicts of interest between stockholders and bondholders are known as:

A) trustee costs.
B) financial distress costs.
C) dealer costs.
D) agency costs.
E) underwriting costs.

Answer 1

agency costs.

Question 2

Junk bonds is a term used to describe bonds:

A) of highest quality.
B) issued by junk yards.
C) with short periods to maturity.
D) with low yields to maturity.
E) with relatively higher probabilities of default.

Answer 2

with relatively higher probabilities of default.

Question 3

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

A) no action by debtholders since these are equity holder concerns.
B) positive agency costs, as bondholders impose various restrictions and covenants, which will diminish firm value.
C) investments of the same risk class that the firm is in.
D) undertaking scale enhancing projects.
E) lower agency costs, as shareholders have more control over the firm's assets.

Answer 3

positive agency costs, as bondholders impose various restrictions and covenants, which will diminish firm value.

Question 4

The TrunkLine Company will earn $60 if it does well. The debtholders are promised payments of $35 if the firm does well. If the firm does poorly the repayment will be $20 because of the dead weight cost of bankruptcy, expected earnings will be $30. The probability of the firm performing poorly or well is 50%. If bondholders are fully aware of these costs what will they pay for the debt? The interest rate on the bonds is 10%.

A) $32.50.
B) $27.50.
C) $25.00.
D) $29.55.
E) $35.00.

Question 5

Indirect costs of financial distress:

A) effectively limit the amount of equity a firm issues.
B) serve as an incentive to increase the financial leverage of a firm.
C) include direct costs such as legal and accounting fees.
D) include the costs incurred by a firm as it tries to avoid seeking bankruptcy protection.

Question 6

The main difference between a positive and negative covenants is(are):

A) a positive covenant is one you must not do while a negative covenant must be carried out.
B) actions that you must do regularly versus periodically.
C) a positive covenant is one you must do while a negative covenant is to limit actions the firm can take.
D) no difference as they are both restrictive.

Question 7

The value of a firm in financial distress is diminished if the firm:

A) has no bankruptcy risk.
B) is declared solvent and does not undergo financial reorganization.
C) is a partnership.
D) both is declared bankrupt and proceeds to be liquidated; and is a partnership.
E) both is declared bankrupt and proceeds to be liquidated; and is declared insolvent and undergoes financial reorganization.

Question 8

If the firm issues debt but writes protective and restrictive covenants into the loan contract, then the debt may be issued at a(an) _____ interest rate compared with otherwise similar debt.

A) significantly higher
B) slightly higher
C) equal
D) lower

Question 9

One of the indirect costs of bankruptcy is the incentive for managers to take large risks. When following this strategy, the firm will:

A) rank all projects and take the project which results in the highest expected value of the firm.
B) rank all projects and take the project which results in the highest expected value of the firm's bonds.
C) rank all projects and take the project which results in the highest expected value of the firm's stock.
D) always take the low risk project.

Question 10

Given realistic estimates of the probability and cost of bankruptcy, the future costs of a possible bankruptcy are borne by:

A) by all investors in the firm.
B) debtholders only because if default occurs interest and principal payments are not made.
C) equity holders because debtholders will pay less providing less cash for the equity holders.
D) management because if the firm defaults they will lose their jobs.

Question 11

Although the use of debt provides tax benefits to the firm, debt also puts pressure on the firms 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) meet both interest and dividend payments which when met increase the firm cash flow.
D) meet increased tax payments thereby increasing firm value.

Question 12

The optimal capital structure has been achieved when the:

A) debt-equity ratio is equal to 1.
B) weight of equity is equal to the weight of debt.
C) cost of equity is maximized given a pre-tax cost of debt.
D) debt-equity ratio selected results in the lowest possible weighed average cost of capital.

Question 13

Covenants restricting the use of leasing and additional borrowings primarily protect:

A) the equity holders from added risk of default.
B) the debtholders from the added risk of dilution of their claims.
C) the debtholders from the transfer of assets.
D) the management from having to pay agency costs.

Question 14

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 the positive NPVs.
B) the firm accepting negative NPV projects that it would clearly reject in an all equity firm.
C) bondholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the benefits of the project.
D) both the firm always choosing projects with the positive NPVs; and stockholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the benefits of the project.
E) both the firm turning down positive NPV projects that it would clearly accept in an all equity firm; and stockholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the benefits of the project.

Question 15

TL Company has expected earnings of $75 in one year if it does well and $25 if it does poorly. The firm has outstanding debt of $50 that is due in one year. However, given the financial distress costs, the debtholders will only receive $40 in one year if the firm does well and $15 if it does poorly. There is a 60 percent chance the firm will do well and a 40 percent chance that it will do poorly. What is the current value of the debt if the interest rate on bonds is 8 percent?

A) $27.78
B) $27.50
C) $30.00
D) $26.67
E) $28.40

Question 16

The TrunkLine Company debtholders are promised payments of $35 if the firm does well, but will receive only $20 if the firm does poorly. If the bonds are selling at a price of $25, the promised return to the bondholders is approximately:

A) 2.90%.
B) 40.00%.
C) 27.30%.
D) 16.86%.
E) 100.00%.

Question 17

While difficult to determine exactly, Lawrence A. Weiss estimated the distress costs to be about ____________ of firm value.

A) 1%.
B) 3.1%.
C) 5-6%.
D) 8-10%.

Question 18

The possibility of bankruptcy has a negative effect on the value of the firm because:

A) increased bankruptcy risk lowers value.
B) reorganization is costless but risk is not.
C) a bankruptcy has real costs associated with it.
D) value enhancing strategies are no longer available.

Question 19

When graphing firm value against debt levels, the debt level that maximizes the value of the firm is the level where:

A) the increase in the present value of distress costs from an additional dollar of debt is greater than the increase in the present value of the debt tax shield.
B) the increase in the present value of distress costs from an additional dollar of debt is equal to the increase in the present value of the debt tax shield.
C) the increase in the present value of distress costs from an additional dollar of debt is less than the increase of the present value of the debt tax shield.
D) distress costs as well as debt tax shields are zero.
E) distress costs as well as debt tax shields are maximized.

Question 20

Indirect costs of bankruptcy are born principally by:

A) bondholders.
B) stockholders.
C) managers.
D) the Federal government.
E) the firm's suppliers.

Question 21

In Miller's model, when the quantity (1-T_c)(1-T_s) = (1-T_b), 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 tax shield on debt is exactly offset by higher levels of dividends.
E) the tax shield on debt is exactly offset by higher capital gains.

Question 22

Given the following information, leverage will add how much value to the unlevered firm per dollar of debt? Corporate tax rate: 34%
Personal tax rate on income from bonds: 20%
Personal tax rate on income from stocks: 0%

A) $0.825.
B) $0.528.
C) $0.175.
D) $0.472.

Question 23

The pecking order states how financing should be raised. In order to avoid asymmetric information problems and misinterpretation of whether management is sending a signals on security overvaluation the firm's first rule is to:

A) finance with internally generated funds as there is no market interaction.
B) always issue debt then the market won't know when management thinks the security is overvalued.
C) reduce asymmetry before any financing activity.
D) increase the financial slack to reduce the reliance on internally generated funds.

Question 24

The free cash flow hypothesis states:

A) that firms with greater free cash flow will pay more in dividends reducing the risk of financial distress.
B) that firms with greater free cash flow should issue new equity to force managers to minimize wasting resources and to work harder.
C) that issuing debt requires interest and principal payments reducing the potential of management to waste resources.
D) that issuing equity reduces the potential of management to waste resources.

Question 25

Issuing debt instead of new equity in a closely held firm more likely:

A) causes the owners-managers to work less hard and shirk their duties as they have less capital at risk.
B) causes the owner-managers to consume more perquisites because the cost is passed to the debtholders.
C) causes both more shirking and perquisite consumption since the government provides a tax shield on debt.
D) cause agency costs to fall as owner-managers do not need to worry about other shareholders.
E) cause the owner-manager to reduce shirking and perquisite consumption as the excess cashflow must be used to meet debt payments.

Question 26

The Lanoi Company has EBIT of $30,000 and market value debt of $150,000 outstanding with an 8% coupon rate. The cost of equity for an all equity firm would be 12%. Lanoi has a 30% corporate tax rate. Investors face a 20% tax rate on debt receipts and a 12% rate on equity. Determine the value of Lanoi.

A) $130,500.
B) $142,698.
C) $248,537.
D) $209,500.
E) $332,143.

Question 27

The value of the firm is the sum of all claims against it. These marketed and non-marketed claims:

A) increase in value together and are both bought and sold in the financial markets.
B) trade-off against one another in value with marketed claims bought and sold in the financial markets but not non-marketable claims.
C) decrease in value together and are both bought and sold in the financial markets.
D) trade-off against one another in value with both marketed and non-marketed claims bought and sold in the financial markets.

Question 28

When small companies issue large stock offerings, we can expect owner managers to:

A) increase both leisure time and work related amenities.
B) decrease both leisure time and work related amenities.
C) increase leisure time but decrease work related amenities.
D) decrease leisure time and increase work related amenities.
E) decrease leisure time but keep work related amenities the same.

Question 29

Given the following information, leverage will add how much value to the unlevered firm per dollar of debt? Corporate tax rate: 30%
Personal tax rate on income from bonds: 20%
Personal tax rate on income from stocks: 0%

A) $0.125.
B) $0.472.
C) $0.528.
D) $0.825.

Question 30

The optimal capital structure:

A) will be the same for all firms in the same industry.
B) will remain constant over time unless the firm makes an acquisition.
C) of a firm will vary over time as taxes and market conditions change.
D) places more emphasis on the operations of a firm rather than the financing of a firm.
E) is unaffected by changes in the financial markets.

Question 31

The Zercon Company has EBIT of $50,000 and market value debt of $100,000 outstanding with a 9% coupon rate. The cost of equity for an all equity firm would be 14%. Zercon has a 35% corporate tax rate. Investors face a 20% tax rate on debt receipts and a 15% rate on equity. Determine the value of Zercon.

A) $263,080.
B) $332,143.
C) $258,537.
D) $162,948.
E) $120,000.

Question 32

Which of the following is true when a firm has level coupon debt outstanding and growth opportunities?

A) The firm should be 100% debt financed because the greater the debt the greater tax shield.
B) 100% debt financing is suboptimal because increased firm value does not increase the current interest needed to shield income today.
C) Firm value will only increase if the debt level is increased to 100%.
D) The high growth firm will have high debt ratios as they need greater financing.

Question 33

The basic lesson of MM theory is that the value of a firm is dependent upon the:

A) capital structure of the firm.
B) total cash flows of the firm.
C) percentage of a firm to which the bondholders have a claim.
D) tax claim placed on the firm by the government.
E) size of the stockholders claims on the firm.

Question 34

Given the following information, leverage will add how much value to the unlevered firm per dollar of debt? Corporate tax rate: 34%
Personal tax rate on income from bonds: 50%
Personal tax rate on income from stocks: 10%

A) -$0.188.
B) $0.340.
C) $0.633.
D) -$0.050.

Question 35

Given the following information, leverage will add how much value to the unlevered firm per dollar of debt? Corporate tax rate: 34%
Personal tax rate on income from bonds: 10%
Personal tax rate on income from stocks: 50%

A) -$0.188.
B) $0.340.
C) $0.633.
D) -$0.050.

Question 36

Given the following information, leverage will add how much value to the unlevered firm per dollar of debt? Corporate tax rate: 34%
Personal tax rate on income from bonds: 30%
Personal tax rate on income from stocks: 30%

A) $0.246.
B) $0.340.
C) $0.006.
D) -$0.050.

Question 37

When firms issue more debt, the tax shield on debt ____, the agency costs on debt (i.e., costs of financial distress) ____, and the agency costs on equity ____.

A) increases; increases; increases
B) decreases; decreases; decreases
C) increases; increases; decreases
D) decreases; decreases; increases
E) increases; decreases; decreases

Question 38

What three factors are important to consider in determining a target debt to equity ratio?

A) Taxes, asset types, and pecking order and financial slack.
B) Asset types, uncertainty of operating income, and pecking order and financial slack.
C) Taxes, financial slack and pecking order, and uncertainty of operating income.
D) Taxes, asset types, and uncertainty of operating income.

Question 39

The introduction of personal taxes may reveal a disadvantage to the use of debt if the:

A) personal tax rate on the distribution of income to stockholders is less than the personal tax rate on interest income.
B) personal tax rate on the distribution of income to stockholders is greater than the personal tax rate on interest income.
C) personal tax rate on the distribution of income to stockholders is equal to the personal tax rate on interest income.
D) the personal tax rate on interest income is zero.

Question 40

Suppose a Miller equilibrium exists with corporate tax rate of 30% and personal tax rate on income from bonds of 35%. What is the personal tax rate on income from stocks?

A) 10.05%.
B) 7.1%.
C) 45.5%.
D) 0.0%.

Question 41

The All-Mine Corporation is deciding whether to invest in a new project. The project would have to be financed by equity, the cost is $2000 and will return $2500 or 25% in one year. The discount rate for both bonds and stock is 15% and the tax rate is zero. The predicted cashflows are $4500 in a good economy, $3000 in an average, economy and $1000 in a poor economy. Each economic outcome is equally likely and the promised debt repayment is $3000. Should the company take the project? What is the value of firm and its components before and after the project addition?

Question 42

The optimal capital structure of a firm _____ the marketed claims and _____ the nonmarketed claims against the cash flows of the firm.

A) minimizes; minimizes
B) minimizes; maximizes
C) maximizes; minimizes
D) maximizes; maximizes

Question 43

Your firm has a debt-equity ratio of.60. Your cost of equity is 11% and your after-tax cost of debt is 7%. What will your cost of equity be if the target capital structure becomes a 50/50 mix of debt and equity?

A) 9.50%.
B) 10.50%.
C) 11.00%.
D) 11.25%.
E) 12.00%.

Question 44

The Do-All-Right Marketing Research firm has promised payments to their bondholders that total $100. The company believes that there is a 85% chance that the cash flow will be sufficient to meet these claims. However, there is a 15% chance that cash flows will fall short, in which case total earnings are expected to be $65. If the bonds sell in the market for $84, what is an estimate of the bankruptcy costs for Do-All-Right? Assume a cost of debt of 10%.

Question 45

Studies have found that firms with high proportions of intangible assets are likely to use ____________ debt compared with firms with low proportions of intangible assets.

A) more
B) the same amount of
C) less
D) either more or the same amount of

Question 46

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 is a disadvantage to debt.
C) firms will incur large agency costs of short term debt by issuing long term debt.
D) both debt is more risky than equity; and bankruptcy is a disadvantage to debt.
E) both bankruptcy is a disadvantage to debt; and firms will incur large agency costs of short term debt by issuing long term debt.

Question 47

Rotomax Inc. has recently undertaken a lot of new ventures and borrowed a huge sum of money from the market. Currently, its face value of debt face equals $150 (all figures are in millions). The firm's assets will be worth either $200 (boom) or $135 (recession) next year. Currently, it has a new project that will generate $60 next year with certainty. The investment needed for this project is $52. Assume that probability of each state is 0.50.
How much is this project opportunity worth? How much is the project opportunity worth to current equity holders if they have to finance the project by equity? Will the current shareholders be interested in investing in this project?

Question 48

Is there an easily identifiable debt-equity ratio that will maximize the value of a firm? Why or why not?

Question 49

The optimal capital structure will tend to include more debt for firms with:

A) the highest depreciation deductions.
B) the lowest marginal tax rate.
C) substantial tax shields from other sources.
D) lower probability of financial distress.
E) less taxable income.

Question 50

Describe some of the sources of business risk and financial risk. Do financial decision makers have the ability to "trade off" one type of risk for the other?

Question 51

Establishing a capital structure for a firm is not simple. Although financial theory guides the process, there is no simple formula. List and explain four main items that one should consider in determining the capital structure.

Question 52

Given a situation where the corporate tax rate is 34%, and the personal tax rate on dividends is 28%, what must the personal tax rate on interest be to achieve the Miller equilibrium?

Question 53

The Aggie Company has EBIT of $70,000 and market value debt of $100,000 outstanding with a 9% coupon rate. The cost of equity for an all equity firm would be 14%. Aggie has a 35% corporate tax rate. Investors face a 20% tax rate on debt receipts and a 15% rate on equity. Determine the value of Aggie.

A) $120,000.
B) $162,948.
C) $258,537.
D) $263,080.
E) $355,938.