Question 1

According to the trade-off theory, more profitable firms should have more debt and thus higher debt ratios on average.

Accepted Answer

A) True 
 B)False  True

Question 2

Suppose that your firm's current unlevered value, V*, is $800,000, and its marginal corporate tax rate is 21 percent. Also, you model the firm's PV of financial distress as a function of its debt level according to the relation: PV of financial distress = 800,000 × (D/V*)2. What is the firm's levered value if it issues $200,000 of perpetual debt to buy back stock?

Accepted Answer

A) $792,000. 
B) $869,555. 
C) $920,000. 
D) $350,000. 
A) $792,000. 
B) $869,555. 
C) $920,000. 
D) $350,000. A

Question 3

When (1 − Tp)= (1 − TpE)(1 − Tc), the impact of corporate and personal taxes makes the debt policy decision less significant.

Accepted Answer

A) True 
 B)False  True

Question 4

What is the relative tax advantage of debt? (TC = corporate tax rate; TpE = personal tax rate on equity income; and Tp = personal tax rate on interest income.)

Accepted Answer

A)    
B)    
C)    
D)    
A)    
B)    
C)    
D)

Question 5

Assuming that bonds are sold at a fair price, the benefits from the interest tax shield go to the

Accepted Answer

A) managers of the firm. 
B) bondholders of the firm. 
C) stockholders of the firm. 
D) lawyers of the firm. 
A) managers of the firm. 
B) bondholders of the firm. 
C) stockholders of the firm. 
D) lawyers of the firm.

Question 6

Firm A and Firm B are identical except that A is incorporated while B is an unlimited liability partnership. Both have assets worth $500,000 ($500K)funded with a debt ratio of 40 percent. Suppose that the assets suddenly become worthless, what is the maximum possible loss to the equityholders of each company?

Accepted Answer

A) Firm A: $300K; Firm B: $500K 
B) Firm A: $200K; Firm B: $300K 
C) Firm A: $500K; Firm B: $200K 
D) Firm A: $500K; Firm B: $500K 
A) Firm A: $300K; Firm B: $500K 
B) Firm A: $200K; Firm B: $300K 
C) Firm A: $500K; Firm B: $200K 
D) Firm A: $500K; Firm B: $500K

Question 7

When financial distress is a possibility, the value of a levered firm is a function 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

Accepted Answer

A) I only 
B) I + II 
C) I + II − III 
D) I + II - III − IV 
A) I only 
B) I + II 
C) I + II − III 
D) I + II - III − IV

Question 8

Inclusion of restrictions in a bond contract leads to

Accepted Answer

A) higher agency costs. 
B) higher bankruptcy costs. 
C) higher interest costs. 
D) lower agency costs. 
A) higher agency costs. 
B) higher bankruptcy costs. 
C) higher interest costs. 
D) lower agency costs.

Question 9

Why does MM Proposition I not hold in the presence of corporate taxes?

Accepted Answer

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. 
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.

Question 10

What are some of the possible consequences of financial distress?
I.Bondholders, who face the prospect of getting only part of their money back, will likely 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.

Accepted Answer

A) I only 
B) II only 
C) III only 
D) I and II only 
A) I only 
B) II only 
C) III only 
D) I and II only

Question 11

Briefly discuss bankruptcy costs.

Accepted Answer

There are direct and indirect costs to b

Question 12

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 marginal corporate tax rate is 21 percent.)

Accepted Answer

A) Investors paying personal tax of 17.5 percent 
B) Investors paying personal tax of 21 percent 
C) Investors paying personal tax of 53 percent 
D) Tax-exempt personal investors 
A) Investors paying personal tax of 17.5 percent 
B) Investors paying personal tax of 21 percent 
C) Investors paying personal tax of 53 percent 
D) Tax-exempt personal investors

Question 13

If a firm borrows $50 million for one year at an interest rate of 9 percent, what is the present value of the interest tax shield? Assume a 21 percent marginal corporate tax rate.

Accepted Answer

A) $50.00 million 
B) $17.50 million 
C) $1.45 million 
D) $0.87 million 
A) $50.00 million 
B) $17.50 million 
C) $1.45 million 
D) $0.87 million

Question 14

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

Accepted Answer

Generally, levered firms pay less tax th

Question 15

When faced with financial distress, managers of firms acting on behalf of their shareholders' interests will tend to:
I.issue large quantities of low-quality debt versus low quantities of high-quality debt;
II.favor paying high dividends to shareholders;
III.delay the onset of bankruptcy as long as they can

Accepted Answer

A) I only 
B) II only 
C) III only 
D) I, II, and III 
A) I only 
B) II only 
C) III only 
D) I, II, and III

Question 16

For every dollar of operating income paid out as equity income, the shareholder realizes

Accepted Answer

A) (1 − Tp). 
B) (1 − Tp
E) (1 − T
C) . 
C) (1 − Tc). 
D) 1/(1 − Tp). 
A) (1 − Tp). 
B) (1 − Tp
E) (1 − T
C) . 
C) (1 − Tc). 
D) 1/(1 − Tp).

Question 17

If a firm permanently borrows $50 million at an interest rate of 10 percent, what is the present value of the interest tax shield? Assume a 21 percent marginal corporate tax rate.

Accepted Answer

A) $50.0 million 
B) $25.0 million 
C) $10.5 million 
D) $1.5 million 
A) $50.0 million 
B) $25.0 million 
C) $10.5 million 
D) $1.5 million

Question 18

The pecking order theory of capital structure predicts that

Accepted Answer

A) if two firms are equally profitable, the more rapidly growing firm will end up borrowing more, other things equal. 
B) firms prefer equity to debt financing. 
C) firms prefer financing by debt versus internally generated cash. 
D) high-risk firms will end up borrowing more. 
A) if two firms are equally profitable, the more rapidly growing firm will end up borrowing more, other things equal. 
B) firms prefer equity to debt financing. 
C) firms prefer financing by debt versus internally generated cash. 
D) high-risk firms will end up borrowing more.

Question 19

If a firm permanently borrows $100 million at an interest rate of 8 percent, what is the present value of the interest tax shield? (Assume that the marginal corporate tax rate is 21 percent.)

Accepted Answer

A) $8.00 million 
B) $5.60 million 
C) $21.00 million 
D) $26.67 million 
A) $8.00 million 
B) $5.60 million 
C) $21.00 million 
D) $26.67 million

Question 20

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

Accepted Answer

A) True 
 B)False

Exam 18: How Much Should a Corporation Borrow

According to the trade-off theory, more profitable firms should have more debt and thus higher debt ratios on average.

When (1 − Tp)= (1 − TpE)(1 − Tc), the impact of corporate and personal taxes makes the debt policy decision less significant.

What is the relative tax advantage of debt? (TC = corporate tax rate; TpE = personal tax rate on equity income; and Tp = personal tax rate on interest income.)

Assuming that bonds are sold at a fair price, the benefits from the interest tax shield go to the

When financial distress is a possibility, the value of a levered firm is a function 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

Inclusion of restrictions in a bond contract leads to

Why does MM Proposition I not hold in the presence of corporate taxes?

Briefly discuss bankruptcy costs.

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 marginal corporate tax rate is 21 percent.)

If a firm borrows $50 million for one year at an interest rate of 9 percent, what is the present value of the interest tax shield? Assume a 21 percent marginal corporate tax rate.

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

For every dollar of operating income paid out as equity income, the shareholder realizes

If a firm permanently borrows $50 million at an interest rate of 10 percent, what is the present value of the interest tax shield? Assume a 21 percent marginal corporate tax rate.

The pecking order theory of capital structure predicts that

If a firm permanently borrows $100 million at an interest rate of 8 percent, what is the present value of the interest tax shield? (Assume that the marginal corporate tax rate is 21 percent.)

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

Introduction to Corporate Finance

How to Calculate Present Values

Valuing Bonds

The Value of Common Stocks

Net Present Value and Other Investment Criteria

Making Investment Decisions With the Net Present Value Rule

Introduction to Risk and Return

Portfolio Theory and the Capital Asset Pricing Model

Risk and the Cost of Capital

Project Analysis

How to Ensure That Projects Truly Have Positive Npvs

Agency Problems and Investment

Efficient Markets and Behavioral Finance

An Overview of Corporate Financing

How Corporations Issue Securities

Payout Policy

Does Debt Policy Matter

Financing and Valuation

Understanding Options

Valuing Options

Real Options

Credit Risk and the Value of Corporate Debt

The Many Different Kinds of Debt

Leasing

Managing Risk

Managing International Risks

Financial Analysis

Financial Planning

Working Capital Management

Mergers

Corporate Restructuring

Governance and Corporate Control Around the World

Filters

When (1 − T_p)= (1 − T_pE)(1 − T_c), the impact of corporate and personal taxes makes the debt policy decision less significant.

What is the relative tax advantage of debt? (T_C = corporate tax rate; T_pE = personal tax rate on equity income; and T_p = personal tax rate on interest income.)