Question 1

Indirect insolvency costs will often increase when a company is in financial stress and may even push the company into insolvency.

Accepted Answer

Indirect insolvency costs can include things like loss of reputation, decreased morale and productivity among employees, and legal fees. These costs can create a negative cycle that makes it harder for a struggling company to recover and stay afloat, ultimately increasing the risk of insolvency.

Question 2

Issuing debt is less expensive than issuing shares.

Accepted Answer

Issuing debt typically carries lower costs than issuing shares, as interest rates on debt are often lower than expected returns for shareholders. Additionally, issuing shares dilutes the ownership of existing shareholders, whereas issuing debt does not.

Question 3

Direct-insolvency costs are considered transaction costs and occur when a company must navigate the insolvency process.

Accepted Answer

Direct-insolvency costs are transaction costs that a company must incur to navigate the insolvency process. Examples of direct-insolvency costs include legal costs, court fees, and professional fees.

Question 4

Under the M&M assumptions with tax, the value of the company with debt is the value of the company without debt plus the present value of the interest tax shield.

Accepted Answer

This is a correct statement under the Modigliani-Miller (M&M) assumptions when considering the effect of tax on the value of a levered firm. The interest tax shield is a benefit that arises from the tax-deductibility of interest payments on debt. According to M&M, the value of a levered firm is equal to the value of an unlevered firm plus the present value of the interest tax shield, since the tax shield reduces the firm's overall cost of capital and increases its cash flows, which in turn enhances its value.

Question 5

The enterprise value of a company is the value of equity minus the value of debt.

Accepted Answer

The enterprise value of a company is the value of equity plus the value of debt. It is calculated by adding the market value of a company's debt and equity, then subtracting the cash and cash equivalents held by the company.

Question 6

M&M Proposition 2 states that the required rate of return on a company's shares are related to the debt-to-equity ratio.

Accepted Answer

M&M Proposition 2 states that the required rate of return on a company's shares is directly related to the company's debt-to-equity ratio. Specifically, as the proportion of debt in the company's capital structure increases, the required rate of return on equity also increases. This is because investors demand a higher return to compensate for the additional risk associated with a higher level of debt.

Question 7

When a company gets closer to financial distress causing expected insolvency costs to increase, lenders will often charge the company a lower interest rate in order to reduce the chance of an actual insolvency occurring.

Accepted Answer

This statement is false. When a company is approaching financial distress, lenders become more risk averse and may charge the company a higher interest rate to compensate for the increased risk of default.

Question 8

M&M Proposition 1 states that the capital structure of a company does not affect the required rate of return on a company's assets, while M&M Proposition 2 shows that the required rate of return on company's equity does change with capital structure decisions.

Accepted Answer

M&M Proposition 1, also known as the Modigliani-Miller Theorem, states that the value of a company is determined by its cash flows and the risk of those cash flows, and that the capital structure of the company does not affect the required rate of return on a company's assets. M&M Proposition 2, on the other hand, shows that the required rate of return on company's equity does change with capital structure decisions. Therefore, the statement in the question is true, and the answer is A.

Question 9

When calculating free cash flow, it is important to include interest and principal payments.

Accepted Answer

Free cash flow is calculated by taking operating cash flow and subtracting capital expenditures; it does not include interest and principal payments as those are financing activities, not operating activities.

Question 10

Indirect insolvency costs include changes in customer and supplier behaviour that negatively affect the company.

Accepted Answer

Indirect insolvency costs refer to the negative impacts on a company caused by changes in customer and supplier behavior, such as customers refusing to do business with the company or suppliers demanding upfront payment. These costs are considered indirect because they are not directly related to the financial obligations of the company, but rather the consequences of their insolvency on their business relationships.

Question 11

Unlike direct insolvency costs, indirect costs are not considered transactions costs.

Accepted Answer

Indirect costs refer to the costs that are not directly related to the insolvency process, such as the loss of reputation, decreased customer confidence, loss of key employees, and decreased market value. These costs are considered transactions costs because they are a result of the insolvency event.

Question 12

M&M Proposition 1 assumes that the mix of debt and equity that a company chooses does not affect real investment policy.

Accepted Answer

According to the Modigliani-Miller (M&M) Proposition 1, the mix of debt and equity that a company chooses does not affect its real investment policy. This proposition is based on the assumptions of perfect capital markets, no taxes, no transaction costs, no bankruptcy costs, and investors having the same information. However, in the real world, these assumptions may not hold true, and the mix of debt and equity a company chooses may affect its real investment policy.

Question 13

Minimising the cost of a company's financing activities also maximises the total value of the company.

Accepted Answer

Minimizing the cost of financing activities such as debt and equity can increase the company's profitability and cash flow, leading to an increase in the overall value of the company. This is because lowering financing costs means that the company has access to cheaper capital which in turn benefits the company's financial performance, leading to higher stock prices and shareholder value.

Question 14

Increasing a company's outstanding equity will increase company leverage.

Accepted Answer

Increasing a company's outstanding equity does not increase the company's leverage because equity is a form of financing that does not have to be repaid and does not involve interest expenses. Leverage refers to the degree to which a company uses debt financing to fund its operations, and increasing equity does not affect the company's debt levels.

Question 15

With no debt, the WACC is the cost of equity plus the required rate of return on the company's underlying assets.

Accepted Answer

The WACC (Weighted Average Cost of Capital) with no debt is equal to the cost of equity, as there is no debt to factor into the calculation. The required rate of return on the company's underlying assets is not added separately.

Question 16

Direct insolvency costs are considered small when compared to indirect costs.

Accepted Answer

Direct insolvency costs, such as legal and administrative expenses, are typically smaller than indirect costs, which include lost sales, damaged reputation, and operational disruptions.

Question 17

More debt in the capital structure provides managers with an incentive to maximise cash flows, but also makes them want to take on negative NPV projects.

Accepted Answer

More debt in the capital structure can incentivize managers to maximize cash flows to meet debt obligations, but it generally discourages taking on negative NPV projects due to the increased risk of financial distress.

Question 18

If a company has debt and pays tax, the present value of the tax shield is the amount of debt outstanding times the tax rate.

Accepted Answer

The present value of the tax shield is calculated by multiplying the amount of debt outstanding by the tax rate and discounting it to the present value. This is a commonly used method to measure the tax benefits of debt financing.

Question 19

Insolvency and agency costs both act as limits on the amount of debt in the capital structure.

Accepted Answer

Insolvency refers to the risk of a company being unable to fulfill its debt obligations, which limits the amount of debt it can take on. Agency costs arise due to the conflicts of interest between different stakeholders in a company, such as shareholders and managers. These costs can increase as debt levels rise, as creditors may require more monitoring and control over the company's operations. Both insolvency and agency costs, therefore, act as limits on the amount of debt that a company can include in its capital structure.

Question 20

A financial restructuring can change the value of a company's real assets, such as property, plant and equipment.

Accepted Answer

Financial restructuring typically involves changes to a company's capital structure, such as debt and equity, rather than altering the value of its real assets.

Quiz 16: Capital Structure Policy