Chapter 17

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Indirect costs of financial distress:

effectively limit the amount of equity a firm issues.

serve as an incentive to increase the financial leverage of a firm.

include direct costs such as legal and accounting fees.

include the costs incurred by a firm as it tries to avoid seeking bankruptcy protection. (correct)

Although the use of debt provides tax benefits to the firm, debt also puts pressure on the firms to:

meet interest and principal payments which if not met can put the company into financial distress (correct)

make dividend payments which if not met can put the company into financial distress.

meet both interest and dividend payments which when met increase the firm cash flow.

meet increased tax payments thereby increasing firm value.

See pic

$32.50.

$27.50.

$25.00. (correct)

$29.55.

TL Company

$27.78 Signup and view all the answers

The Trunk Line Company

40.00%. Signup and view all the answers

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

a bankruptcy has real costs associated with it. Signup and view all the answers

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

equity holders because debt holders will pay less providing less cash for the equity Signup and view all the answers

While difficult to determine exactly, White, Altman, and Weiss estimated the distress costs to be about _______ of the firm's market value.

3%. Signup and view all the answers

The value of a firm in financial distress diminishes if the firm:

is declared bankrupt and proceeds to be liquidated, or is declared insolvent and undergoes financial reorganization. Signup and view all the answers

Conflicts of interest between stockholders and bondholders are known as:

agency costs. Signup and view all the answers

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

rank all projects and take the project which results in the highest expected value of the firm's stock. Signup and view all the answers

The optimal capital structure has been achieved when the:

debt-equity ratio selected results in the lowest possible weighed average cost of capital. Signup and view all the answers

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

positive agency costs, as bondholders impose various restrictions and covenants, which will diminish the firm value. Signup and view all the answers

Indirect costs of bankruptcy are born principally by:

stockholders. Signup and view all the answers

One of the indirect bankruptcy costs is the incentive toward underinvestment. Following this strategy may result in:

both the firm turning down positive NPV projects that it would 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. Signup and view all the answers

"Junk bond" is a term used to describe bonds:

with relatively higher probabilities of default. Signup and view all the answers

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

a positive covenant is one you must do, while a negative covenant limits actions the firm can take. Signup and view all the answers

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

the debt holders from the added risk of dilution of their claims. Signup and view all the answers

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.

lower Signup and view all the answers

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

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. Signup and view all the answers

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

total cash flows of the firm. Signup and view all the answers

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

trade-off against one another in value with marketed claims bought and sold in the financial markets but not non-marketable claims. Signup and view all the answers

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

increase both leisure time and work-related amenities. Signup and view all the answers

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 ___

increases; increases; decreases Signup and view all the answers

The free cash flow hypothesis states:

that issuing debt requires interest and principal payments reducing the potential of management to waste resources. Signup and view all the answers

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

cause the owner-manager to reduce shirking and perquisite consumption as the excess cash flow must be used to meet debt payments. Signup and view all the answers

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

finance with internally generated funds as there is no market interaction. Signup and view all the answers

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

100% debt financing is suboptimal because increased firm value does not increase the current interest needed to shield income today. Signup and view all the answers

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

personal tax rate on the distribution of income to stockholders is less than the personal tax rate on interest income. Signup and view all the answers

In the Miller Model, when the quantity (1-Tc)(1-Ts) = (1-Tb), then:

the tax shield on debt is exactly offset by higher personal taxes paid on interest income. Signup and view all the answers

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

Taxes, asset types, and uncertainty of operating income. Signup and view all the answers

The Zercon Company

$263,080. Signup and view all the answers

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

7.1%. Signup and view all the answers

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%

-$0.188. Signup and view all the answers

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%

$0.633. Signup and view all the answers

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%

$0.340. Signup and view all the answers

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%

$0.175. Signup and view all the answers

The Lanoi Company

$290,500 Signup and view all the answers

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%

$0.125. Signup and view all the answers

The optimal capital structure:

of a firm will vary over time as taxes and market conditions change. Signup and view all the answers

The MM theory with taxes implies that firms should issue maximum debt. In practice, this is not true because:

bankruptcy is a disadvantage to debt. Signup and view all the answers

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?

12.00%. Signup and view all the answers

The Aggie Company

$394062.5 Signup and view all the answers

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

lower probability of financial distress. Signup and view all the answers

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

maximizes; minimizes Signup and view all the answers

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.

less Signup and view all the answers

Rotomax Inc.

The project is worth $60 - $54 = $8. If equity holders finance the project on their own, then the payoff is: [0.50 * (200 ) + 0.50 * (135) ] + 60 - 54 - 150 = $23.5 On the other hand, if they do not undertake the project, the pay-off is: 0.50 * (200 - 150) + 0.50 * 0 = 0.50 * 50 + 0.50 * 0 = $25 Hence, current shareholders will not be interested in the project Signup and view all the answers

The Do-All-Right Marketing Research firm

The expected amount bondholders receive if cash flows fall short under bankruptcy is: $84 = [($100 * .85) + (X * .15)]/1.1 => X = $49.34 Without bankruptcy costs, the bonds would sell for: [(100 * .85) + ($65 * .15)]/1.1 => $86.14 Therefore, estimated bankruptcy costs must be $65.00 - $49.34 = $15.66. Impact on price is (.15(15.66))/1.1 = $2.14 Signup and view all the answers

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?

(1 -.34) (1 -.28) = (1 - Tb) =>.4752 = (1 - Tb) => Tb =.5248 Signup and view all the answers