Question 1

An investor owns 500 shares of stock in a Montreal firm with a debt/equity ratio = 1.0. The investor prefers a debt/equity ratio = 1.5. If the stock price is $2 per share, what should the investor do?

Accepted Answer

To achieve a debt/equity ratio of 1.5, the investor needs to have $1.50 in debt for every $1.00 in equity. Initially, the investor has 500 shares at $2 each, totaling $1,000 in equity with no debt. To adjust the ratio to 1.5, the investor should aim for a total debt of $1,500 (1.5 times the original equity). By borrowing $1,500 and buying 750 new shares at $2 each, the investor spends all the borrowed money on shares, increasing the total equity to $2,500 (original $1,000 + $1,500 from new shares) while incurring $1,500 in debt, achieving the desired debt/equity ratio of 1.5.

Question 2

M&M Proposition I with tax states that the value of a levered firm increases as the:

Accepted Answer

M&M Proposition I with tax posits that the value of a levered firm is higher than the value of an unlevered firm by the tax shield on debt. This implies that as the debt-equity ratio increases, the value of the firm increases due to the tax benefits of debt.

Question 3

The implicit costs associated with corporate default, such as lost sales, are the __________ of the firm.

Accepted Answer

Indirect bankruptcy costs include the implicit costs associated with corporate default, such as lost sales, damage to reputation, and the loss of customers or suppliers, which can significantly impact a firm's value beyond the direct legal and administrative costs of bankruptcy.

Question 4

An investor owns 500 shares of stock in a firm with a debt/equity ratio = 1.0. The investor prefers an all-equity firm. If the stock price is $2 per share, what should the investor do?

Accepted Answer

To achieve an all-equity position, the investor should sell shares equivalent to the firm's debt portion and lend the proceeds. Selling 250 shares and lending $500 aligns with the firm's debt/equity ratio of 1.0.

Question 5

Lance owns 200 shares of ABC stock with a current market value of $10 a share. ABC has an annual EBIT of $400,000 and a cost of debt of 8%. Currently, ABC is 100% equity financed with 100,000 shares outstanding. ABC is going to a 25% debt capital structure by issuing debt and redeeming shares. Ignore taxes. What does Lance have to do to return his capital structure position to approximately its original position?

Accepted Answer

The answer of Lance owns 200 shares of ABC stock...

Question 6

Homemade leverage makes which one of the following irrelevant?

Accepted Answer

Homemade leverage refers to the use of personal borrowing by investors to change the overall amount of financial leverage (debt) to which they are exposed. According to the Modigliani-Miller theorem, in a world without taxes, bankruptcy costs, and other market imperfections, a firm's capital structure is irrelevant to its value. This means that investors can replicate any corporate capital structure through personal borrowing, making the firm's capital structure irrelevant to its value.

Question 7

The cost of capital for a firm which has no debt is called the _____ cost of capital.

Accepted Answer

Unlevered cost of capital refers to the cost of capital for a firm that has no debt, meaning it is financed entirely by equity.

Question 8

Which one of the following statements concerning bankruptcy is correct?

Accepted Answer

E) An implicit cost of bankruptcy is the loss of key employees. This is correct because during financial distress and bankruptcy, firms often face the risk of losing key employees who may seek more stable employment opportunities, which is considered an implicit or indirect cost of bankruptcy.

Question 9

Suppose you work for the CFO of Danforth, Inc. He believes sales and operating income will be sharply higher each year for the foreseeable future. If he seeks to maximize earnings per share, he should _____________. (Assume there are no taxes.)

Accepted Answer

The answer of Suppose you work for the CFO of...

Question 10

The optimal capital structure of a firm maximizes the value of the firm while:

Accepted Answer

The optimal capital structure minimizes the firm's cost of capital, which in turn maximizes the firm's value by balancing the benefits of debt (like tax shields) against the costs (like financial distress).

Question 11

The extent to which a firm relies on debt is referred to as:

Accepted Answer

Financial leverage refers to the extent to which a firm uses borrowed money (debt) to finance its operations and growth. It measures the degree to which a company is funding its activities through debt as opposed to wholly owned funds.

Question 12

When choosing a capital structure, the objective of the firm should be to:

Accepted Answer

The objective of choosing a capital structure should be to minimize the firm's weighted average cost of capital (WACC). A lower WACC indicates a lower cost of financing the firm's operations, which can lead to an increase in the firm's value.

Question 13

M&M Proposition II with tax supports the argument that a firm's:

Accepted Answer

M&M Proposition II with tax posits that the cost of equity increases as a firm leverages up (i.e., increases its debt-equity ratio), because equity holders demand a higher return to compensate for the increased risk associated with higher levels of debt.

Question 14

You have computed the break-even point between a capital structure that has no debt and one that has debt. Assume there are no taxes. At the break-even level, the:

Accepted Answer

At the break-even level, the firm is just earning enough to cover the cost of the debt, meaning it can pay the interest on its debt without either gaining or losing money as a result of the leverage.

Question 15

Which one of the following receives the highest priority in the distribution of assets under a bankruptcy proceeding?

Accepted Answer

Administrative expenses related to the bankruptcy receive the highest priority in the distribution of assets during a bankruptcy proceeding to ensure that the costs of managing and finalizing the bankruptcy are covered.

Question 16

The explicit and implicit costs associated with corporate default are the ___________ of the firm.

Accepted Answer

Financial distress costs are the explicit and implicit costs associated with corporate default.

Question 17

The value of a restructuring is equal to the net present value of the:

Accepted Answer

The value of a restructuring is equal to the net present value of the resulting change in the total value of the firm. This encompasses all changes in value, not just changes in debt or equity specifically.

Question 18

The optimal capital structure has been achieved when the:

Accepted Answer

The optimal capital structure is achieved when the firm has balanced its debt and equity in such a way that the weighted average cost of capital (WACC) is minimized. This does not necessarily mean equal weights of debt and equity (as in B), a specific debt-equity ratio like 1 (as in A), or situations where the cost of debt exceeds the cost of equity (as in D) or the cost of equity is maximized (as in C). Lowering the WACC increases the value of the firm and is thus considered optimal.

Question 19

Which of the following describes a correct priority of claims in a bankruptcy liquidation?

Accepted Answer

In a bankruptcy liquidation, the priority of claims typically starts with bankruptcy expenses (such as legal and administrative fees), followed by specific priority claims like wages owed to employees, then unsecured creditors (which include consumer claims), and finally, shareholders, with preferred stockholders ahead of common stockholders. This order ensures that the costs of the bankruptcy process are covered first, then employees and other priority claims are paid, followed by general creditors, and if any assets remain, shareholders may receive something.

Question 20

The explicit costs associated with corporate default, such as legal expenses, are the ________ of the firm.

Accepted Answer

Direct bankruptcy costs include the explicit costs associated with a firm's default, such as legal and administrative expenses.

Quiz 16: Financial Leverage and Capital Structure Policy