Chap018.pdf

Chapter 18 - How Much Should a Corporation Borrow?

Chapter 18 How Much Should a Corporation Borrow? Multiple Choice Questions

1. The main advantage of debt financing for a firm is: I) no SEC registration is required for bond issue II) interest expense of a firm is tax deductible III) unlevered firms have higher value than levered firms A. I only B. II only C. III only D. I and III only

2. If a firm permanently borrows $100 million at an interest rate of 8%, what is the present value of the interest tax shield? (Assume that the tax rate is 30%) A. $8.00 million B. $5.6 million C. $30 million D. $26.67 million E. None of the above

3. If a firm borrows $50 million for one year at an interest rate of 10%, what is the present value of the interest tax shield? Assume a 30% tax rate. (Approximately.) A. $1.364 million B. $1.5 million C. $1.0 million D. $4.545 million E. None of the above

4. In order to find the present value of the tax shields provided by debt, the discount rate used is the: A. cost of capital B. cost of equity C. cost of debt D. none of the above

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5. In order to calculate the tax shields provided by debt, the tax rate used is the: A. average corporate tax rate B. marginal corporate tax rate C. average of shareholders' tax rates D. average of bondholders' tax rates

6. If a firm permanently borrows $50 million at an interest rate of 10%, what is the present value of the interest tax shield? Assume a 30% tax rate. A. $50.0 million B. $25.0 million C. $15.0 million D. $1.5 million

7. If a firm borrows $50 million for one year at an interest rate of 9%, what is the present value of the interest tax shield? Assume a 30% tax rate. A. $50.00 million B. $17.50 million C. $1.445 million D. $1.239 million

8. In order to calculate the tax shield effect of interest payment for a corporation, always use the: I) average corporate tax rate II) marginal corporate tax rate III) state mandated tax rate A. I only B. II only C. III only D. I and III only

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9. If a corporation cannot use its interest payments to get tax shield for a particular year because it has suffered a loss, it is still possible to get the tax shield because of the: I) carry back provision that allows corporations to carry back the loss and receive a tax refund up to the amount of taxes paid in the previous two years. II) carry forward provision that allows corporations to carry forward the loss and use it to shield income in subsequent years. A. I only B. II only C. I and II D. none of the above

10. The reason that MM Proposition I does not hold good in the presence of corporate taxes is because: A. Levered firms pay lower taxes when compared with identical unlevered firms B. Bondholders require higher rates of return compared with stockholders C. Earnings per share are no longer relevant with taxes D. Dividends are no longer relevant with taxes

11. The positive value to the firm by adding debt to the capital structure in the presence of corporate taxes is: I) Due to the extra cash flow going to the investors of the firm rather than the tax authorities II) Due to the earnings before interest and taxes being fully taxed at the corporate rate III) Because personal-tax rates are the same as corporate tax rates A. I only B. II only C. III only D. II and III only

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12. MM Proposition I with corporate taxes states that: I) Capital structure can affect firm value by an amount that is equal to the present value of the interest tax shield II) By raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total value III) Firm value is maximized at an all debt capital structure A. I only B. II only C. III only D. I, II, and III

13. Bombay Company's balance sheet is as follows: (NWC = net working capital; LTA = long term assets; D = debt; E = equity; V = firm value):

According to MM's Proposition I corrected for taxes, what will be the change in company value if Bombay issues $200 of equity and uses it to make a permanent reduction in the company's debt? Assume a 35% tax rate. A. +$140 B. +$70 C. $0 D. -$70

14. MM's Proposition I corrected for the inclusion of corporate income taxes is expressed as: A. VL = VU B. VL = VU + D(1 - TC) C. VL = VU + (TC)(D) D. VU = VL + (TC)(D)

15. Assuming that bonds are sold at a fair price, the benefits from the tax shield go to the: A. managers of the firm B. bondholders of the firm C. stockholders of the firm D. lawyers of the firm

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16. Assume the corporate tax rate is 30%. The firm has no debt in its capital structure. It is valued at $100 million. What would be the value of the firm if it issued $50 in perpetual debt and repurchased the equity? A. $65 B. $115 C. $100 D. None of the above

17. The relative tax advantage of debt with personal and corporate taxes is: Where: TC = Corporate tax rate; TpE = Personal tax rate on equity income; and Tp = Personal tax rate on interest income. A. B. C. D.

18. The relative tax advantage of debt with personal and corporate taxes is: Where: TC = (Corporate tax rate) = 35%; TpE = Personal tax rate on equity income = 30%; and Tp = Personal tax rate on interest income = 20%: (approximately) A. 1.76 B. 1.16 C. 1.35 D. None of the given ones

19. For every dollar of operating income paid out as interest, the bondholder realizes: A. (1 - Tp) B. (1 - TpE) (1 - TC) C. (1 - TC) D. None of the above

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20. For every dollar of operating income paid out as equity income, the shareholder realizes: A. (1 - Tp) B. (1 - TpE) (1 - TC) C. (1 - TC) D. None of the above

21. Suppose that a company can direct $1 to either debt interest or capital gains for equity investors. If there were no personal taxes on capital gains, which of the following investors would not care how the money was channeled? (The corporate tax rate is 35%) A. Investors paying personal tax of 17.5% B. Investors paying personal tax of 35% C. Investors paying personal tax of 53% D. None of the above

22. In Miller's model, when the quantity (1 - TC)(1 - TpE) = (1 - Tp), 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. None of the above

23. Suppose that a company can direct $1 to either debt interest or capital gains for equity investors. If half of equity income were subject to personal tax (e.g.: half is taxable dividends and half is tax-free capital gains) which investor would not care how the money is channeled? (The corporate tax rate is 35%) A. Investors paying zero personal tax B. Investors paying a personal tax rate of 53% C. Investors paying a personal tax rate of 17.5% D. None of the above

Given the following information, leverage will add how much value to the unlevered firm per dollar of debt?

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24. (Approximately) Corporate tax rate: 34% Personal tax rate on income from bonds: 30% Personal tax rate on income from stocks: 20% A. $0.66 B. $0.25 C. -$0.66 D. -$0.34

25. Corporate tax rate: 34% Personal tax rate on income from bonds: 40% Personal tax rate on income from stocks: 30% A. $0.246 B. $0.340 C. $0.006 D. $0.23

26. 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. None of the above

27. In Miller's model, when Personal tax rate on income from bonds is equal to the personal tax rate on income from stocks: A. relative advantage of debt depends only on the corporate tax rate B. relative advantage of debt depends only on the personal tax rate on interest income C. relative advantage of debt depends only on the personal tax rate on income from equity D. none of the above

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28. The MM theory with taxes implies that firms should issue maximum debt. In practice, this is not true because: I) Debt is more risky than equity II) Bankruptcy and its attendant costs is a disadvantage to debt III) The payment of personal taxes may offset the tax benefit of debt A. I only B. II only C. III only D. II and III only

29. Although the use of debt provides tax benefits to the firm, debt also puts pressure on the firm to: I) Meet interest and principal payments which if not met can put the company into financial distress II) Make dividend payments which if not met can put the company into financial distress III) Meet both interest and dividend payments which when met increase the firm cash flow IV) Meet increased tax payments thereby increasing firm value A. I only B. II only C. II and III only D. III and IV only

30. The costs of financial distress depend on the: I) probability of financial distress II) corporate and personal tax rates III) the magnitude of costs encountered if financial distress occurs A. I only B. I and II only C. I, II and III D. I and III only

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31. The value of the firm in the presence of debt may risk financial distress. Bankruptcy, the most severe type of financial distress, has an impact on value by: I) the risk or probability that it may occur II) the level of risk aversion investors have to debt III) the total value of the firm being siphoned off to cover bankruptcy costs A. I only B. I and II only C. III only D. II only

32. When financial distress is a possibility, the value of a levered firm consists of: I) value of the firm if all-equity-financed II) present value of tax shield III) present value of costs of financial distress IV) present value of omitted dividend payments A. I only B. I + II C. I + II - III D. I + II - III - IV

33. According to the trade-off theory of capital structure: A. optimal capital structure is reached when the present value of tax savings on account of additional borrowing is just offset by increases in the present value of costs of distress. B. optimal capital structure is reached when stockholders' right to default is balanced by the the bondholders' right to get interest and principal payments. C. optimal capital structure is reached when the benefits of limited liability is just offset by the value of the lawyers' claim. D. none of the above

34. Indirect costs of bankruptcy are borne principally by: A. Bondholders B. Stockholders C. Managers D. The federal government

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35. Which of the following statement(s) about financial distress is(are) true: I) always ends in bankruptcy II) firms can postpone bankruptcy for many years III) ultimately the firm may recover and avoid bankruptcy altogether A. I only B. II only C. II and III only D. III only

36. What are some of the possible consequences of financial distress? I) Bondholders, who face the prospect of getting only part of their money back, are likely to want the company to take additional risks. II) Equity investors would like the company to cut its dividend payments to conserve cash. III) Equity investors would like the firm to shift toward riskier lines of business. A. I only B. II only C. III only D. I and II only

37. Risk shifting implies: A. When faced with bankruptcy, managers tend to invest in high risk, high return projects B. When faced with bankruptcy, managers do not invest more equity capital C. When faced with bankruptcy; managers may make accounting changes to conceal the true extent of the problem D. All of the above

38. When faced with financial distress; managers of firms acting on behalf of their shareholders' interests will: A. favor high risk, high return projects even if they have negative NPV B. refuse to invest in low risk, low return projects with positive NPVs C. delay the onset of bankruptcy as long as they can D. all of the above

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39. When faced with financial distress; managers of firms acting on behalf of their shareholders' interests will: A. favor issuing large quantity of low quality debt to low quantity of high quality debt B. favor paying high dividends to the shareholders C. delay the onset of bankruptcy as long as they can D. all of the above

40. One of the indirect costs to bankruptcy is the incentive toward under investment. Following this strategy may result in: I) the firm always choosing projects with the positive NPVs II) stockholders turning down low risk low return but positive NPV projects III) stockholders would declare and receive high cash dividends A. I only B. II only C. III only D. II and III only

41. When shareholders pursue selfish strategies such as taking large risks or paying excessive dividends, these will result in: I) no action by debtholders since these are equity holder concerns II) positive agency costs, as bondholders impose various restrictions and covenants, which will diminish firm value III) investments of the same risk class that the firm is in A. I only B. II only C. III only D. I and III only

42. Inclusion of restrictions in the bond contract leads to: A. Higher agency costs B. Higher bankruptcy costs C. Higher interest costs D. None the above

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43. The trade-off theory of capital structure predicts that: A. Unprofitable firms should borrow more than profitable ones B. Safe firms should borrow more than risky ones C. Rapidly growing firms should borrow more than mature firms D. Increasing leverage increases firm value

44. The pecking order theory of capital structure predicts that: A. If two firms are equally profitable, the more rapidly growing firm will borrow more, other things equal B. Firms prefer equity to debt financing C. Risky firms will end up borrowing less D. Risky firms will end up borrowing more

45. The pecking order theory of capital structure implies that: I) Risky firms will end up borrowing more II) Firms prefer internal finance III) Firms prefer debt to equity when external financing is required A. I only B. II only C. II and III only D. III only

46. According to Rajan and Zingales study, debt ratios of individual companies depend on: I) Size: Large firms have higher debt ratios. II) Tangible assets: Firms with high ratios of fixed assets to total assets have higher debt ratios. III) Profitability: More profitable firms have lower debt ratios. IV) Market to book: Firms with higher ratios of market-to-book value have lower debt ratios. V) Market structure: Firms with monopoly power have higher debt ratios. A. I and II only B. I, II and III only C. I, II, III and IV only D. I, II, III, IV and V

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47. Financial slack includes: I) Cash II) Marketable securities III) Readily salable real assets IV) Ready access to debt markets or bank loans A. I only B. IV only C. III only D. I, II, III, and IV

48. What signal is sent to the market when a firm decides to issue new stock to raise capital? A. Bond markets are overpriced B. Bond markets are underpriced C. Stock price is too low D. Stock price is too high

49. Under the trade off theory, how will a government loan guarantee impact financing? A. Prefer to issue debt B. Prefer to issue stock C. Prefer internal money D. No impact

True / False Questions

50. The present value of the interest tax shield is the same regardless of whether the firm plans to borrow permanently or temporarily. True False

51. Always use the average corporate tax rate to calculate the tax shields for firms. True False

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52. MM's Proposition I corrected for corporate taxes states that: Value of levered firm = Value (all equity financed) + PV tax shield. True False

53. The value of a levered firm is given by: Value of levered firm = Value (all equity financed) + (TC) * (D) This assumes that the debt is perpetual debt. True False

54. Personal taxes on interest income and equity income will always increase the advantage of debt to a firm. True False

55. When (1 - Tp) = (1 - TpE)(1 - TC), corporate and personal taxes cancel to make debt policy irrelevant. True False

56. Financial distress occurs when promises to creditors are not honored or honored with great difficulty. True False

57. When cost of financial distress is included, the value of a levered firm is given by: Value of levered firm = Value (all equity financed) + PV (tax shield) - PV (costs of financial distress). True False

58. The right to default is valuable for the stockholders of firms. True False

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59. Financial distress always results in bankruptcy. True False

60. Risk shifting, refusing to contribute equity and playing for time are some of the consequences of firms facing bankruptcy. True False

61. According to the trade-off theory, more profitable firms should have more debt and thus the highest debt ratios. True False

62. The pecking order theory implies that firms prefer internal to external financing. True False

63. The existing tax code encourages a preference for equity over debt in corporate financing. True False

64. A firm bankrupt from excess use of debt, which receives government bailout funds and government loan guarantees is incentivized to issue more high risk debt. True False

Short Answer Questions

65. Briefly explain how interest tax shields contribute to the value of stockholders' equity.

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66. State Modigliani-Miller's proposition I corrected to include corporate income taxes.

67. Discuss the basic idea behind Miller's arguments about debt and taxes.

68. What is the relative tax advantage of debt when corporate and personal taxes are considered?

69. State how the present value of tax shield is changed when personal taxes are included.

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70. How does Modigliani-Miller's proposition I is modified when taxes and financial distress costs are considered?

71. Briefly explain bankruptcy costs.

72. Discuss some examples of the conflicts of interest that may arise between bondholders and stockholders when a firm is in financial distress.

73. Briefly explain the trade-off theory of capital structure.

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74. Explain the pecking order theory of capital structure.

75. Explain the impact of government loan guarantees on corporate financing.

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Chapter 18 How Much Should a Corporation Borrow? Answer Key

Multiple Choice Questions

1. The main advantage of debt financing for a firm is: I) no SEC registration is required for bond issue II) interest expense of a firm is tax deductible III) unlevered firms have higher value than levered firms A. I only B. II only C. III only D. I and III only

Type: Medium

2. If a firm permanently borrows $100 million at an interest rate of 8%, what is the present value of the interest tax shield? (Assume that the tax rate is 30%) A. $8.00 million B. $5.6 million C. $30 million D. $26.67 million E. None of the above PV of interest tax shield = (0.3)(100) = $30 million

Type: Medium

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3. If a firm borrows $50 million for one year at an interest rate of 10%, what is the present value of the interest tax shield? Assume a 30% tax rate. (Approximately.) A. $1.364 million B. $1.5 million C. $1.0 million D. $4.545 million E. None of the above PV of interest tax shield = ((0.3)(50)(0.1))/1.1 = $1.364

Type: Difficult

4. In order to find the present value of the tax shields provided by debt, the discount rate used is the: A. cost of capital B. cost of equity C. cost of debt D. none of the above

Type: Difficult

5. In order to calculate the tax shields provided by debt, the tax rate used is the: A. average corporate tax rate B. marginal corporate tax rate C. average of shareholders' tax rates D. average of bondholders' tax rates

Type: Medium

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6. If a firm permanently borrows $50 million at an interest rate of 10%, what is the present value of the interest tax shield? Assume a 30% tax rate. A. $50.0 million B. $25.0 million C. $15.0 million D. $1.5 million PV of interest tax shield = (0.30)(50) = $15.0 million

Type: Medium

7. If a firm borrows $50 million for one year at an interest rate of 9%, what is the present value of the interest tax shield? Assume a 30% tax rate. A. $50.00 million B. $17.50 million C. $1.445 million D. $1.239 million PV of interest tax shield = [(0.3)(50)(0.09)]/1.09 = $1.445 million

Type: Difficult

8. In order to calculate the tax shield effect of interest payment for a corporation, always use the: I) average corporate tax rate II) marginal corporate tax rate III) state mandated tax rate A. I only B. II only C. III only D. I and III only

Type: Medium

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9. If a corporation cannot use its interest payments to get tax shield for a particular year because it has suffered a loss, it is still possible to get the tax shield because of the: I) carry back provision that allows corporations to carry back the loss and receive a tax refund up to the amount of taxes paid in the previous two years. II) carry forward provision that allows corporations to carry forward the loss and use it to shield income in subsequent years. A. I only B. II only C. I and II D. none of the above

Type: Difficult

10. The reason that MM Proposition I does not hold good in the presence of corporate taxes is because: A. Levered firms pay lower taxes when compared with identical unlevered firms B. Bondholders require higher rates of return compared with stockholders C. Earnings per share are no longer relevant with taxes D. Dividends are no longer relevant with taxes

Type: Easy

11. The positive value to the firm by adding debt to the capital structure in the presence of corporate taxes is: I) Due to the extra cash flow going to the investors of the firm rather than the tax authorities II) Due to the earnings before interest and taxes being fully taxed at the corporate rate III) Because personal-tax rates are the same as corporate tax rates A. I only B. II only C. III only D. II and III only

Type: Medium

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12. MM Proposition I with corporate taxes states that: I) Capital structure can affect firm value by an amount that is equal to the present value of the interest tax shield II) By raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total value III) Firm value is maximized at an all debt capital structure A. I only B. II only C. III only D. I, II, and III

Type: Difficult

13. Bombay Company's balance sheet is as follows: (NWC = net working capital; LTA = long term assets; D = debt; E = equity; V = firm value):

According to MM's Proposition I corrected for taxes, what will be the change in company value if Bombay issues $200 of equity and uses it to make a permanent reduction in the company's debt? Assume a 35% tax rate. A. +$140 B. +$70 C. $0 D. -$70 PV of tax shield = -200 (0.35) = -$70 million

Type: Difficult

14. MM's Proposition I corrected for the inclusion of corporate income taxes is expressed as: A. VL = VU B. VL = VU + D(1 - TC) C. VL = VU + (TC)(D) D. VU = VL + (TC)(D)

Type: Medium

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15. Assuming that bonds are sold at a fair price, the benefits from the tax shield go to the: A. managers of the firm B. bondholders of the firm C. stockholders of the firm D. lawyers of the firm

Type: Medium

16. Assume the corporate tax rate is 30%. The firm has no debt in its capital structure. It is valued at $100 million. What would be the value of the firm if it issued $50 in perpetual debt and repurchased the equity? A. $65 B. $115 C. $100 D. None of the above VU = 100; (TC)(B) = 0.3(50) = 15; VL = VU + TCB = 100 + 15 = $115

Type: Medium

17. The relative tax advantage of debt with personal and corporate taxes is: Where: TC = Corporate tax rate; TpE = Personal tax rate on equity income; and Tp = Personal tax rate on interest income. A. B. C. D.

Type: Medium

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18. The relative tax advantage of debt with personal and corporate taxes is: Where: TC = (Corporate tax rate) = 35%; TpE = Personal tax rate on equity income = 30%; and Tp = Personal tax rate on interest income = 20%: (approximately) A. 1.76 B. 1.16 C. 1.35 D. None of the given ones Relative advantage = (1 - 0.2)/[(1 - 0.3)(1 - 0.35)] = 1.76

Type: Difficult

19. For every dollar of operating income paid out as interest, the bondholder realizes: A. (1 - Tp) B. (1 - TpE) (1 - TC) C. (1 - TC) D. None of the above

Type: Medium

20. For every dollar of operating income paid out as equity income, the shareholder realizes: A. (1 - Tp) B. (1 - TpE) (1 - TC) C. (1 - TC) D. None of the above

Type: Medium

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21. Suppose that a company can direct $1 to either debt interest or capital gains for equity investors. If there were no personal taxes on capital gains, which of the following investors would not care how the money was channeled? (The corporate tax rate is 35%) A. Investors paying personal tax of 17.5% B. Investors paying personal tax of 35% C. Investors paying personal tax of 53% D. None of the above

Type: Difficult

22. In Miller's model, when the quantity (1 - TC)(1 - TpE) = (1 - Tp), 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. None of the above

Type: Difficult

23. Suppose that a company can direct $1 to either debt interest or capital gains for equity investors. If half of equity income were subject to personal tax (e.g.: half is taxable dividends and half is tax-free capital gains) which investor would not care how the money is channeled? (The corporate tax rate is 35%) A. Investors paying zero personal tax B. Investors paying a personal tax rate of 53% C. Investors paying a personal tax rate of 17.5% D. None of the above

Type: Difficult

Given the following information, leverage will add how much value to the unlevered firm per dollar of debt?

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24. (Approximately) Corporate tax rate: 34% Personal tax rate on income from bonds: 30% Personal tax rate on income from stocks: 20% A. $0.66 B. $0.25 C. -$0.66 D. -$0.34 [1 - ((1 - TC)(1 - TpE)/(1 - Tp))]D = [1 - ((0.66)(1 - 0.2)/(1 0.3)]D = 0.25D; $0.25

Type: Difficult

25. Corporate tax rate: 34% Personal tax rate on income from bonds: 40% Personal tax rate on income from stocks: 30% A. $0.246 B. $0.340 C. $0.006 D. $0.23 [1 - ((1 - TC)(1 - TpE)/(1 - Tp))]D = [1 - ((0.66)(0.7)/0.6]D = 0.23D; $0.23

Type: Difficult

26. 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. None of the above [1 - ((1 - 0.34)(1 - 0.5)/(1 - 0.1))] = 1 - (0.33/0.9) = 1 - 0.3667 = 0.6333

Type: Difficult

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27. In Miller's model, when Personal tax rate on income from bonds is equal to the personal tax rate on income from stocks: A. relative advantage of debt depends only on the corporate tax rate B. relative advantage of debt depends only on the personal tax rate on interest income C. relative advantage of debt depends only on the personal tax rate on income from equity D. none of the above

Type: Medium

28. The MM theory with taxes implies that firms should issue maximum debt. In practice, this is not true because: I) Debt is more risky than equity II) Bankruptcy and its attendant costs is a disadvantage to debt III) The payment of personal taxes may offset the tax benefit of debt A. I only B. II only C. III only D. II and III only

Type: Medium

29. Although the use of debt provides tax benefits to the firm, debt also puts pressure on the firm to: I) Meet interest and principal payments which if not met can put the company into financial distress II) Make dividend payments which if not met can put the company into financial distress III) Meet both interest and dividend payments which when met increase the firm cash flow IV) Meet increased tax payments thereby increasing firm value A. I only B. II only C. II and III only D. III and IV only

Type: Difficult

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30. The costs of financial distress depend on the: I) probability of financial distress II) corporate and personal tax rates III) the magnitude of costs encountered if financial distress occurs A. I only B. I and II only C. I, II and III D. I and III only

Type: Medium

31. The value of the firm in the presence of debt may risk financial distress. Bankruptcy, the most severe type of financial distress, has an impact on value by: I) the risk or probability that it may occur II) the level of risk aversion investors have to debt III) the total value of the firm being siphoned off to cover bankruptcy costs A. I only B. I and II only C. III only D. II only

Type: Difficult

32. When financial distress is a possibility, the value of a levered firm consists of: I) value of the firm if all-equity-financed II) present value of tax shield III) present value of costs of financial distress IV) present value of omitted dividend payments A. I only B. I + II C. I + II - III D. I + II - III - IV

Type: Medium

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33. According to the trade-off theory of capital structure: A. optimal capital structure is reached when the present value of tax savings on account of additional borrowing is just offset by increases in the present value of costs of distress. B. optimal capital structure is reached when stockholders' right to default is balanced by the the bondholders' right to get interest and principal payments. C. optimal capital structure is reached when the benefits of limited liability is just offset by the value of the lawyers' claim. D. none of the above

Type: Difficult

34. Indirect costs of bankruptcy are borne principally by: A. Bondholders B. Stockholders C. Managers D. The federal government

Type: Easy

35. Which of the following statement(s) about financial distress is(are) true: I) always ends in bankruptcy II) firms can postpone bankruptcy for many years III) ultimately the firm may recover and avoid bankruptcy altogether A. I only B. II only C. II and III only D. III only

Type: Medium

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36. What are some of the possible consequences of financial distress? I) Bondholders, who face the prospect of getting only part of their money back, are likely to want the company to take additional risks. II) Equity investors would like the company to cut its dividend payments to conserve cash. III) Equity investors would like the firm to shift toward riskier lines of business. A. I only B. II only C. III only D. I and II only

Type: Difficult

37. Risk shifting implies: A. When faced with bankruptcy, managers tend to invest in high risk, high return projects B. When faced with bankruptcy, managers do not invest more equity capital C. When faced with bankruptcy; managers may make accounting changes to conceal the true extent of the problem D. All of the above

Type: Difficult

38. When faced with financial distress; managers of firms acting on behalf of their shareholders' interests will: A. favor high risk, high return projects even if they have negative NPV B. refuse to invest in low risk, low return projects with positive NPVs C. delay the onset of bankruptcy as long as they can D. all of the above

Type: Difficult

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39. When faced with financial distress; managers of firms acting on behalf of their shareholders' interests will: A. favor issuing large quantity of low quality debt to low quantity of high quality debt B. favor paying high dividends to the shareholders C. delay the onset of bankruptcy as long as they can D. all of the above

Type: Difficult

40. One of the indirect costs to bankruptcy is the incentive toward under investment. Following this strategy may result in: I) the firm always choosing projects with the positive NPVs II) stockholders turning down low risk low return but positive NPV projects III) stockholders would declare and receive high cash dividends A. I only B. II only C. III only D. II and III only

Type: Difficult

41. When shareholders pursue selfish strategies such as taking large risks or paying excessive dividends, these will result in: I) no action by debtholders since these are equity holder concerns II) positive agency costs, as bondholders impose various restrictions and covenants, which will diminish firm value III) investments of the same risk class that the firm is in A. I only B. II only C. III only D. I and III only

Type: Medium

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42. Inclusion of restrictions in the bond contract leads to: A. Higher agency costs B. Higher bankruptcy costs C. Higher interest costs D. None the above

Type: Medium

43. The trade-off theory of capital structure predicts that: A. Unprofitable firms should borrow more than profitable ones B. Safe firms should borrow more than risky ones C. Rapidly growing firms should borrow more than mature firms D. Increasing leverage increases firm value

Type: Medium

44. The pecking order theory of capital structure predicts that: A. If two firms are equally profitable, the more rapidly growing firm will borrow more, other things equal B. Firms prefer equity to debt financing C. Risky firms will end up borrowing less D. Risky firms will end up borrowing more

Type: Medium

45. The pecking order theory of capital structure implies that: I) Risky firms will end up borrowing more II) Firms prefer internal finance III) Firms prefer debt to equity when external financing is required A. I only B. II only C. II and III only D. III only

Type: Medium

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46. According to Rajan and Zingales study, debt ratios of individual companies depend on: I) Size: Large firms have higher debt ratios. II) Tangible assets: Firms with high ratios of fixed assets to total assets have higher debt ratios. III) Profitability: More profitable firms have lower debt ratios. IV) Market to book: Firms with higher ratios of market-to-book value have lower debt ratios. V) Market structure: Firms with monopoly power have higher debt ratios. A. I and II only B. I, II and III only C. I, II, III and IV only D. I, II, III, IV and V

Type: Medium

47. Financial slack includes: I) Cash II) Marketable securities III) Readily salable real assets IV) Ready access to debt markets or bank loans A. I only B. IV only C. III only D. I, II, III, and IV

Type: Difficult

48. What signal is sent to the market when a firm decides to issue new stock to raise capital? A. Bond markets are overpriced B. Bond markets are underpriced C. Stock price is too low D. Stock price is too high

Type: Medium

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49. Under the trade off theory, how will a government loan guarantee impact financing? A. Prefer to issue debt B. Prefer to issue stock C. Prefer internal money D. No impact

Type: Medium

True / False Questions

50. The present value of the interest tax shield is the same regardless of whether the firm plans to borrow permanently or temporarily. FALSE

Type: Easy

51. Always use the average corporate tax rate to calculate the tax shields for firms. FALSE

Type: Easy

52. MM's Proposition I corrected for corporate taxes states that: Value of levered firm = Value (all equity financed) + PV tax shield. TRUE

Type: Medium

53. The value of a levered firm is given by: Value of levered firm = Value (all equity financed) + (TC) * (D) This assumes that the debt is perpetual debt. TRUE

Type: Medium

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54. Personal taxes on interest income and equity income will always increase the advantage of debt to a firm. FALSE

Type: Medium

55. When (1 - Tp) = (1 - TpE)(1 - TC), corporate and personal taxes cancel to make debt policy irrelevant. TRUE

Type: Medium

56. Financial distress occurs when promises to creditors are not honored or honored with great difficulty. TRUE

Type: Medium

57. When cost of financial distress is included, the value of a levered firm is given by: Value of levered firm = Value (all equity financed) + PV (tax shield) - PV (costs of financial distress). TRUE

Type: Medium

58. The right to default is valuable for the stockholders of firms. TRUE

Type: Medium

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59. Financial distress always results in bankruptcy. FALSE

Type: Medium

60. Risk shifting, refusing to contribute equity and playing for time are some of the consequences of firms facing bankruptcy. TRUE

Type: Medium

61. According to the trade-off theory, more profitable firms should have more debt and thus the highest debt ratios. TRUE

Type: Medium

62. The pecking order theory implies that firms prefer internal to external financing. TRUE

Type: Medium

63. The existing tax code encourages a preference for equity over debt in corporate financing. FALSE

Type: Medium

64. A firm bankrupt from excess use of debt, which receives government bailout funds and government loan guarantees is incentivized to issue more high risk debt. TRUE

Type: Medium

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Short Answer Questions

65. Briefly explain how interest tax shields contribute to the value of stockholders' equity. Generally, levered firms pay less tax than equivalent unlevered firms. The savings in taxes is called the interest tax shield. Firms can deduct interest payments as expenses, thereby reducing the level of taxable income. Hence levered firms have lower tax payments. This in turn increases the value of the firm.

Type: Difficult

66. State Modigliani-Miller's proposition I corrected to include corporate income taxes. The value of a levered firm is equal to the value of an equivalent unlevered firm plus the present value of tax shields. In the special case of permanent debt: VL = VU + (TC)(D) Where TC = Corporate tax rate.

Type: Medium

67. Discuss the basic idea behind Miller's arguments about debt and taxes. In equilibrium, taxes determine the aggregate amount of corporate debt but not the amount issued by any particular firm. For a given set of tax rates, both corporate and personal, the market will adjust until there is no advantage to any firm issuing more debt.

Type: Difficult

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68. What is the relative tax advantage of debt when corporate and personal taxes are considered? The relative tax advantage of debt can be stated as: (1 - TP)/[(1 - TC)(1 - TPE)] Suppose all equity income is in the form of dividends then TPE = TP, the relative tax advantage of debt is: 1/(1 - TC) In case (1 - TP) = (1 - TC)(1 - TPE), the relative tax advantage is zero.

Type: Difficult

69. State how the present value of tax shield is changed when personal taxes are included. Miller developed a modified form of proposition I by including personal taxes on equity income and interest income. These could be different from corporate taxes. VL = VU + [(1 - (1 - TC)(1 - TPE)/(1 - TP)](D) Where: TC = Corporate tax rate, TPE = personal tax rate on income from equity and TP = personal tax rate on interest income.

Type: Difficult

70. How does Modigliani-Miller's proposition I is modified when taxes and financial distress costs are considered? Financial distress occurs when bondholder contracts are broken or fulfilled with great difficulty. Financial distress could lead to bankruptcy. Financial distress is costly. This is reflected in the market value of the levered firm. Value of a levered firm = Value of an equivalent unlevered firm + PV(tax shield) - PV(cost of financial distress)

Type: Difficult

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71. Briefly explain bankruptcy costs. There are direct and indirect costs to bankruptcy. Direct costs include legal and administrative costs of liquidation or reorganization. Indirect costs of financial distress include impaired ability to conduct business and increased agency costs. Agency costs associated with managerial actions under the threat of bankruptcy are: risk shifting, under-investment or refusal to invest more equity, and milking the property.

Type: Difficult

72. Discuss some examples of the conflicts of interest that may arise between bondholders and stockholders when a firm is in financial distress. When a firm is in distress, the shareholders are interested in protecting the value of their securities and hence take actions that might decrease the value of the firm and hence reduce the debtholders' wealth. Some examples of such actions are risk shifting, refusing to contribute equity capital, milking the assets, playing for time and bait and switch.

Type: Medium

73. Briefly explain the trade-off theory of capital structure. A firm's debt-equity decision can be thought of as a trade-off between interest tax shields and the costs of financial distress. These two interact to provide an optimal capital structure for a firm. This is called the trade-off theory.

Type: Medium

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74. Explain the pecking order theory of capital structure. This theory is based on the observation that, in general, managers know more about the firm's prospects, risks, and values than do outsiders. This asymmetric information affects the choice between internal and external financing and between new issues of debt and equity. The implication is that firms prefer internal financing to external financing. When firms are propelled to go for external financing it prefers debt to equity.

Type: Medium

75. Explain the impact of government loan guarantees on corporate financing. The capital markets naturally punish firms for excess use of debt via default and bankruptcy. Firms naturally will turn away from debt financing and back towards equity financing. Intervention in the capital markets by the government to provide loan guarantees to firms on the brink of failure works in the opposite direction by encouraging further leveraging.

Type: Medium

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Chap018.pdf

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