Corporate Finance Ch. 17

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 costs such as legal and accounting fees.D) Tend to increase as the debt-equity ratio decreases.E) Include the costs incurred by a firm as it tries to avoid seeking bankruptcy protection. E
The value of a firm is maximized when the:A) Cost of equity is maximized.B) Tax rate is zero.C) Levered cost of capital is maximized.D) Weighted average cost of capital is minimized.E) Debt-equity ratio is minimized. D
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 pretax cost of debt.D) Debt-equity ratio is such that the cost of debt exceeds the cost of equity.E) Debt-equity ratio selected results in the lowest possible weighed average cost of capital. E
In a world with taxes and financial distress, when a firm is operating with the optimal capital structure the:A) Debt-equity ratio will be less than optimal.B) Weighted average cost of capital will be maximized.C) Firm will be all-equity financed.D) Required return on assets will be at its maximum point. E) Increased benefit from additional debt is equal to the increased bankruptcy costs of that debt. E
The optimal capital structure of a firm _____ the marketable claims and _____ the non-marketable claims against the cash flows of the firm.A) Minimizes; minimizesB) Minimizes; maximizesC) Maximizes; minimizesD) Maximizes; maximizesE) Equates; (leave blank) C
One of the indirect costs of bankruptcy is the incentive toward under-investment. Under investment generally would result in:A) The firm selecting all projects with positive NPVs.B) The firm turning down positive NPV projects that would clearly be accepted if the firm were all-equity financed.C) Bondholders contributing the full amount of any new investment, but both stockholders and bondholders sharing in the benefits of those investments.D) Shareholders making decisions based on the best interests of the bondholders.E) The firm accepting more projects than it would if the probability of bankruptcy was ignored. B
If a firm issues debt and includes protective covenants in the indenture then the firm’s debt will probably be issued at _____ similar debt without the covenants.A) A variable interest rate rather than the fixed rate paid onB) A lower interest rate thanC) A significantly higher interest rate thanD) An interest rate equal to that ofE) A slightly higher interest rate than B
A firm is currently valued at $300 in a boom and $160 otherwise. The chance of a boom is 35 percent. The firm owes $200 to its debt holders. What is the value of the firm to the shareholders?A) $0B) $35.00C) $27.50D) $209.00E) $9.00 BShareholder value = .35 × MAX[($300 – 200),0] + (1 – .35) × MAX[($160 – 200),0] = $35
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. D
In general, the capital structures used by U.S. firms:A) Tend to overweight debt in relation to equity.B) Are easily explained in terms of earnings volatility.C) Are easily explained by analyzing the types of assets owned by the various firms.D) Tend to be those which maximize the use of the firm’s available tax shelters.E) Vary significantly across industries. E
The MM theory with taxes implies that firms should issue maximum debt. In practice, this does not occur because:A) Debt is more risky than equity.B) Bankruptcy is a disadvantage to debt.C) The weighted average cost of capital is inversely related to the debt-equity ratio.D) The weighted average cost of capital is directly related to the debt-equity ratio.E) U.S. regulations require the debt-equity ratio of publicly-traded firms to be in the range of .3 to .7. B
One of the indirect costs of bankruptcy is the incentive for managers to take large risks. When following this strategy:A) The firm will rank all projects and select the project which results in the highest expected firm value.B) Bondholders expropriate value from stockholders by selecting high-risk projects.C) Stockholders expropriate value from bondholders by selecting high-risk projects.D) The firm will always select the lowest-risk project available.E) The firm will select only all-equity financed projects. C
What’s the difference between business risk and financial risk and what affects each of them? Business risk: The risk of whether or not a firm will be able to generate enough revenue from sales to cover its operating expenses and make a profit. Things that go into sales variability, like CFs, market conditions, industry conditions, COGS, profit margins, competition, overall demand for its products, whether the firm’s assets are concrete, etc.Financial risk: Deals with leverage and debt financing, so it’s whether or not a company can generate enough CFs to make interest payments. Interest rate changes and the weight of debt in the company’s capital structure.
Pecking order theory definition and rules Definition: The cost of financing increases with asymmetric info.Rules:1. Use internal financing as much as possible2. If outside financing is needed, debt should be issued before equity
Implications of the pecking order theory 1. No target D/E ratio2. Profitable firms use less debt3. Companies like financial slack because they’ll need to internally finance projects in the future
Payoff to shareholders after restructuring -Capital gains + Dividends
R0 Expected earnings to unlevered firm/Unlevered equity
Tradeoff theory There’s a tradeoff between the tax benefits of debt and the costs of financial distress
What are the 3 selfish strategies? 1. Incentive to take large risks2. Incentive toward underinvestment3. Milking the property
With corporate taxes and bankruptcy costs, the firm value is maximized where the ____________________________ from the _______________________ is _____________________ by the _______________ in ______________________________. Where the additional benefit from the interest tax shield is just offset by the increase in expected bankruptcy costs

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