Chapter 17 Capital

Structure: Limits to the Use of Debt

1. The explicit costs, such as the legal expenses, associated with corporate default are classified as _____ costs.
A. flotation
B. beta conversion
C. direct bankruptcy
D. indirect bankruptcy
E. unlevered

2. The costs of avoiding a bankruptcy filing by a financially distressed firm are classified as _____ costs.
A. flotation
B. direct bankruptcy
C. indirect bankruptcy
D. financial solvency
E. capital structure

3. The explicit and implicit costs associated with corporate default are referred to as the _____ costs of a firm.
A. flotation
B. default beta
C. direct bankruptcy
D. indirect bankruptcy
E. financial distress

4. 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 direct 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.

5. The legal proceeding for liquidating or reorganizing a firm operating in default is called a:
A. tender offer.
B. bankruptcy.
C. merger.
D. takeover.
E. proxy fight.

6. 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.
7. 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 pre-tax 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.

8. In a world with taxes and financial distress, when a firm is operating with the optimal capital structure:
I. the debt-equity ratio will also be optimal.
II. the weighted average cost of capital will be at its minimal point.
III. the required return on assets will be at its maximum point.
IV. the increased benefit from additional debt is equal to the increased bankruptcy costs of that debt.
A. I and IV only
B. II and III only
C. I and II only
D. II, III, and IV only
E. I, II, and IV only

9. 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.

10. The optimal capital structure of a firm _____ the marketed claims and _____ the nonmarketed claims against the cash
flows of the firm.
A. minimizes; minimizes
B. minimizes; maximizes
C. maximizes; minimizes
D. maximizes; maximizes
E. equates; (leave blank)

11. The optimal capital structure:

A. will be the same for all firms in the same industry.
B. will remain constant over time unless the firm makes an acquisition.
C. of a firm will vary over time as taxes and market conditions change.
D. places more emphasis on the operations of a firm rather than the financing of a firm.
E. is unaffected by changes in the financial markets.

12. The basic lesson of MM theory is that the value of a firm is dependent upon the:
A. capital structure of the firm.
B. total cash flows of the firm.
C. percentage of a firm to which the bondholders have a claim.
D. tax claim placed on the firm by the government.
E. size of the stockholders claims on the firm.
13. Corporations in the U.S. tend to:
A. minimize taxes.
B. underutilize debt.
C. rely less on equity financing than they should.
D. have extremely high debt-equity ratios.
E. rely more heavily on bonds than stocks as the major source of financing.

14. In general, the capital structures used by U.S. firms:

A. tend to overweigh 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.

15. The MM theory with taxes implies that firms should issue maximum debt. In practice, this is not true because:
A. debt is more risky than equity.
B. bankruptcy is a disadvantage to debt.
C. firms will incur large agency costs of short term debt by issuing long term debt.
D. Both debt is more risky than equity; and bankruptcy is a disadvantage to debt.
E. Both bankruptcy is a disadvantage to debt; and firms will incur large agency costs of short term debt by issuing long
term debt.

16. Although the use of debt provides tax benefits to the firm, debt also puts pressure on the firm to:
A. meet interest and principal payments which, if not met, can put the company into financial distress.
B. make dividend payments which if not met can put the company into financial distress.
C. meet both interest and dividend payments which when met increase the firm cash flow.
D. meet increased tax payments thereby increasing firm value.
E. None of these.

17. Given realistic estimates of the probability and cost of bankruptcy, the future costs of a possible bankruptcy are borne
by:
A. all investors in the firm.
B. debtholders only because if default occurs interest and principal payments are not made.
C. shareholders because debtholders will pay less for the debt providing less cash for the shareholders.
D. management because if the firm defaults they will lose their jobs.
E. None of these.

18. Conflicts of interest between stockholders and bondholders are known as:
A. trustee costs.
B. financial distress costs.
C. dealer costs.
D. agency costs.
E. underwriting costs.
19. 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 take the project which results in the highest expected value of the firm.
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 take the low risk project.
E. Both the firm will rank all projects and take the project which results in the highest expected value of the firm; and
bondholders expropriate value from stockholders by selecting high risk projects.

20. One of the indirect costs to bankruptcy is the incentive toward underinvestment. Following this strategy may result
in:
A. the firm always choosing projects with the positive NPVs.
B. the firm turning down positive NPV projects that it would clearly accept in an all equity firm.
C. stockholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the
benefits of the project.
D. Both the firm always choosing projects with the positive NPVs; and stockholders contributing the full amount of
the investment, but both stockholders and bondholders sharing in the benefits of the project.
E. Both the firm turning down positive NPV projects that it would clearly 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.

21. Which of the following is true?

A. A firm with low anticipated profit will likely take on a high level of debt.
B. A successful firm will probably take on zero debt.
C. Rational firms raise debt levels when profits are expected to decline.
D. Rational investors are likely to infer a higher firm value from a zero debt level.
E. Investors will generally view an increase in debt as a positive sign for the firm's value

22. 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.
A. more
B. the same amount of
C. less
D. either more or the same amount of
E. any amount of debt

23. What three factors are important to consider in determining a target debt to equity ratio?
A. Taxes, asset types, and pecking order and financial slack
B. Asset types, uncertainty of operating income, and pecking order and financial slack
C. Taxes, financial slack and pecking order, and uncertainty of operating income
D. Taxes, asset types, and uncertainty of operating income
E. None of these.

24. An exchange may offer:

A. allow customers a 30 day money-back guarantee on the firm's product.
B. allow customers a 90 day warranty on the firm's product from defects.
C. allow bondholders to exchange some debt for stock.
D. allow stockholders to exchange some of their stock for debt.
E. Both allow bondholders to exchange some debt for stock; and allow stockholders to exchange some of their stock
for debt.
25. Which of the following is not empirically true when formulating capital structure policy?
A. Some firms use no debt.
B. Most corporations have low debt-asset ratios.
C. There are no differences in the capital-structure of different industries.
D. Debt levels across industries vary widely.
E. Debt ratios in most countries are considerably less than 100%.

26. When shareholders pursue selfish strategies such as taking large risks or paying excessive dividends, these will result
in:
A. no action by debtholders since these are equity holder concerns.
B. positive agency costs, as bondholders impose various restrictions and covenants which will diminish firm value.
C. investments of the same risk class that the firm is in.
D. undertaking scale enhancing projects.
E. lower agency costs, as shareholders have more control over the firm's assets.

27. Indirect costs of bankruptcy are born principally by:

A. bondholders.
B. stockholders.
C. managers.
D. the federal government.
E. the firm's suppliers.

28. The value of a firm in financial distress is diminished if the firm:

A. is declared bankrupt and proceeds to be liquidated.
B. is declared insolvent and undergoes financial reorganization.
C. is a partnership.
D. Both is declared bankrupt and proceeds to be liquidated; and is a partnership.
E. Both is declared bankrupt and proceeds to be liquidated; and is declared insolvent and undergoes financial
reorganization.

29. Covenants restricting the use of leasing and additional borrowings primarily protect:
A. the equityholders from added risk of default.
B. the debtholders from the added risk of dilution of their claims.
C. the debtholders from the transfer of assets.
D. the management from having to pay agency costs.
E. None of these.

30. If a firm issues debt but writes protective and restrictive covenants into the loan contract, then the firm issues debt
may be issued at a _____ interest rate compared with otherwise similar debt.
A. significantly higher
B. slightly higher
C. equal
D. lower
E. Either significantly higher or slightly higher
31. When graphing firm value against debt levels, the debt level that maximizes the value of the firm is the level where:
A. the increase in the present value of distress costs from an additional dollar of debt is greater than the increase in
the present value of the debt tax shield.
B. 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.
C. the increase in the present value of distress costs from an additional dollar of debt is less than the increase of the
present value of the debt tax shield.
D. distress costs as well as debt tax shields are zero.
E. distress costs as well as debt tax shields are maximized.

32. 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 _____.
A. increases; increase; increase
B. decreases; decrease; decrease
C. increases; increase; decrease
D. decreases; decrease; increase
E. increases; decrease; decrease

33. The free cash flow hypothesis states:

A. that firms with greater free cash flow will pay more in dividends reducing the risk of financial distress.
B. that firms with greater free cash flow should issue new equity to force managers to minimize wasting resources
and to work harder.
C. that issuing debt requires interest and principal payments reducing the potential of management to waste
resources.
D. Both that firms with greater free cash flow will pay more in dividends reducing the risk of financial distress; and
that issuing debt requires interest and principal payments reducing the potential of management to waste resources.
E. Both that firms with greater free cash flow should issue new equity to force managers to minimize wasting resources
and to work harder; and that issuing debt requires interest and principal payments reducing the potential of
management to waste resources.

34. Issuing debt instead of new equity in a closely held firm more likely:
A. causes the owner-manager to work less hard and shirk their duties as they have less capital at risk.
B. causes the owner-manager to consume more perquisites because the cost is passed to the debtholders.
C. causes both more shirking and perquisite consumption since the government provides a tax shield on debt.
D. causes agency costs to fall as owner-managers do not need to worry about other shareholders.
E. causes the owner-manager to reduce shirking and perquisite consumption as the excess cash flow must be used
to meet debt payments.

35. 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:
A. finance with internally generated funds.
B. always issue debt then the market won't know when management thinks the security is overvalued.
C. issue new equity first.
D. issue debt first.
E. None of these.
36. Growth opportunities _______ the _____ of debt financing.
A. increase; advantage
B. decrease; advantage
C. decrease; disadvantage
D. Both increase; advantage and decrease; disadvantage
E. None of these

37. Which of the following industries would tend to have the highest leverage?
A. Drugs
B. Computer
C. Paper
D. Electronics
E. Biological products

38. The introduction of personal taxes may reveal a disadvantage to the use of debt if the:
A. personal tax rate on the distribution of income to stockholders is less than the personal tax rate on interest
income.
B. personal tax rate on the distribution of income to stockholders is greater than the personal tax rate on interest
income.
C. personal tax rate on the distribution of income to stockholders is equal to the personal tax rate on interest income.
D. personal tax rate on interest income is zero.
E. None of these.

39. In Miller model, when the quantity [(1 - Tc)(1 - Ts) = (1 - Tb)], 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. the tax shield on debt is exactly offset by higher levels of dividends.
E. the tax shield on debt is exactly offset by higher capital gains.

40. In a Miller equilibrium, what type of investments do high tax bracket investors tend to hold?
A. Bonds
B. Stocks
C. Debentures
D. Both stocks and bonds.
E. Neither stocks nor bonds.

41. The TrunkLine Company will earn $60 in one year if it does well. The debtholders are promised payments of $35 in
one year if the firm does well. If the firm does poorly, expected earnings in one year will be $30 and the repayment
will be $20 because of the dead weight cost of bankruptcy. The robability of the firm performing poorly or well is 50%.
If bondholders are fully aware of these costs what will they pay for the debt? The interest rate on the bonds is 10%.
A. $25.00
B. $27.50
C. $29.55
D. $32.50
E. $35.00
42. The TrunkLine Company debtholders are promised payments of $35 if the firm does well, but will receive only $20 if
the firm does poorly. Bondholders are willing to pay $25. The promised return to the bondholders is approximately:
A. 2.9%
B. 16.9%
C. 27.3%
D. 40.0%
E. 100%

43. An investment is available that pays a tax-free 6%. The corporate tax rate is 30%. Ignoring risk, what is the pre-tax
return on taxable bonds?
A. 4.20%
B. 6.00%
C. 7.67%
D. 8.57%
E. None of these.

44. 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?
A. 9.50%
B. 10.50%
C. 11.00%
D. 11.25%
E. 12.00%

45. The Aggie Company has EBIT of $50,000 and market value debt of $100,000 outstanding with a 9% coupon rate. The
cost of equity for an all equity firm would be 14%. Aggie has a 35% corporate tax rate. Investors face a 20% tax rate
on debt receipts and a 15% rate on equity. Determine the value of Aggie.
A. $120,000
B. $162,948
C. $258,537
D. $263,080
E. $332,143

46. 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%
A. $-0.050
B. $0.006
C. $0.246
D. $0.340
E. $0.660
47. 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% A. $0.175
B. $0.472
C. $0.528
D. $0.825
E. None of these

48. 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%
A. $-0.050
B. $-0.188
C. $0.188
D. $0.633
E. None of these

49. 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%
A. $-0.050
B. $-0.188
C. $0.367
D. $0.633
E. None of these

50. The Aggie Company has EBIT of $70,000 and market value debt of $100,000 outstanding with a 9% coupon rate. The
cost of equity for an all equity firm would be 14%. Aggie has a 35% corporate tax rate. Investors face a 20% tax rate
on debt receipts and a 15% rate on equity. Determine the value of Aggie.
A. $120,000
B. $162,948
C. $258,537
D. $263,080
E. $355,938

51. 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?
A. 0.0%
B. 7.1%
C. 10.05%
D. 45.5%
E. None of these
52. Given the following information, leverage will add how much value to the unlevered firm per dollar of debt?
Corporate tax rate: 40%
Personal tax rate on income from bonds: 20%
Personal tax rate on income from stocks: 30%
A. $-0.475
B. $0.475
C. $0.525
D. $0.633
E. None of these

53. 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: 50%
A. $-0.050
B. $-0.188
C. $0.367
D. $0.588
E. None of these

54. 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: 30%
A. $-0.050
B. $0.006
C. $0.246
D. $0.340
E. $0.423

55. 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%
A. $0.125
B. $0.472
C. $0.528
D. $0.825
E. None of these

56. Holly Berry Incorporated will earn $40 in one year if it does well. The debtholders are promised payments of $25 in
one year if the firm does well. If the firm does poorly, expected earnings in one year will be $20 and the repayment
will be $15 because of the dead weight cost of bankruptcy. The probability of the firm performing poorly or well is
50%. If bondholders are fully aware of these costs what will they pay for the debt? The interest rate on the bonds is
8%.
A. $18.52
B. $30.00
C. $32.55
D. $35.75
E. $37.04
57. Holly Berry Incorporated debtholders are promised payments of $25 if the firm does well but will receive only $20 if
the firm does poorly. Bondholders are willing to pay $15. The promised return to the bondholders is approximately:
A. 5.65%
B. 45.65%
C. 50.00%
D. 66.67%
E. 100.00%

58. An investment is available that pays a tax-free 7%. The corporate tax rate is 40%. Ignoring risk, what is the pre-tax
return on taxable bonds?
A. 4.20%
B. 7.00%
C. 7.47%
D. 11.67%
E. None of these

59. An investment is available that pays a tax-free 5%. The corporate tax rate is 25%. Ignoring risk, what is the pre-tax
return on taxable bonds?
A. 5%
B. 6.25%
C. 6.67%
D. 7.14%
E. 7.69%.

60. The Lanoi Company has EBIT of $30,000 and market value debt of $150,000 outstanding with an 8% coupon rate. The
cost of equity for an all equity firm would be 12%. Aggie has a 30% corporate tax rate. Investors face a 20% tax rate
on debt receipts and a 12% rate on equity.
Determine the value of Aggie.
A. $130,500
B. $142,698
C. $248,537
D. $209,500
E. $332,143

61. Given the following information, leverage will add how much value to the unlevered firm per dollar of debt?
Corporate tax rate: 35%
Personal tax rate on income from bonds: 25%
Personal tax rate on income from stocks: 30%
A. $-0.625
B. $0.287
C. $0.393
D. $0.635
E. None of these
62. Robotics Incorporated will earn $60 in one year if it does well. The debtholders are promised payments of $40 in one
year if the firm does well. If the firm does poorly, expected earnings in one year will be $10 and the repayment will be
$5 because of the dead weight cost of bankruptcy. The probability of the firm performing poorly or well is 40%. If
bondholders are fully aware of these costs what will they pay for the debt? The interest rate on the bonds is 7%.
A. $17.76
B. $19.73
C. $32.55
D. $38.75
E. $39.04

63. An investment is available that pays a tax-free 8%. The corporate tax rate is 35%. Ignoring risk, what is the pre-tax
return on taxable bonds?
A. 4.20%
B. 5.00%
C. 8.47%
D. 12.3%
E. None of these