Question 1

According to the trade-off theory of capital structure,

Accepted Answer

A) optimal capital structure occurs when the present value of tax savings on account of additional borrowing just offsets the increase in the present value of costs of distress. 
B) optimal capital structure occurs when the stockholders' right to default is balanced by the bondholders' right to get interest and principal payments. 
C) optimal capital structure occurs when the benefits of limited liability is just offset by the value of the firm's lawyers' claims. 
D) None of these options are correct. 
A) optimal capital structure occurs when the present value of tax savings on account of additional borrowing just offsets the increase in the present value of costs of distress. 
B) optimal capital structure occurs when the stockholders' right to default is balanced by the bondholders' right to get interest and principal payments. 
C) optimal capital structure occurs when the benefits of limited liability is just offset by the value of the firm's lawyers' claims. 
D) None of these options are correct.

Question 2

The main advantage of debt financing for a firm is:
I.no SEC registration is required for bond issues;
II.interest expenses are tax deductible;
III.unlevered firms have higher value than levered firms

Accepted Answer

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

Question 3

Compared to a firm with unlimited liability, the limited liability feature of common equity results in a

Accepted Answer

A) lower present value of the interest tax shield. 
B) higher value to equityholders. 
C) leveraged buyout mechanism. 
D) higher value to debtholders. 
A) lower present value of the interest tax shield. 
B) higher value to equityholders. 
C) leveraged buyout mechanism. 
D) higher value to debtholders.

Question 4

Discuss the 1995 results of Rajan and Zingales from the trade-off theory perspective.

Accepted Answer

Large firms tend to have higher debt rat

Question 5

When the costs of financial distress are included, the value of a levered firm is given by Value of levered firm = Value of unlevered firm + PV (tax shield)− PV (costs of financial distress).

Accepted Answer

A) True 
 B)False

Question 6

If a corporation cannot use its interest payments as a tax shield for a particular year because it has suffered a loss, it is still possible to use the tax shield because:
I.the carry-back provision 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.the carry-forward provision allows corporations to carry forward the loss and use it to shield income in subsequent years

Accepted Answer

A) I only 
B) II only 
C) I and II 
D) the firm will lose the tax shield 
A) I only 
B) II only 
C) I and II 
D) the firm will lose the tax shield

Question 7

The pecking order theory of capital structure implies that:
I.high-risk firms will end up borrowing more;
II.firms prefer internal finance;
III.firms prefer debt to equity when external financing is required

Accepted Answer

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

Question 8

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

Accepted Answer

When a firm is in distress, the sharehol

Question 9

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

Accepted Answer

In equilibrium, taxes determine the aggr

Question 10

When shareholders pursue strategies such as taking excessive risks or paying excessive dividends, these will result in:
I.no action by debtholders since these are equityholder concerns;
II.positive agency costs, as bondholders act on various restrictions and covenants, which will diminish firm value;
III.investments of the same risk class that the firm is in

Accepted Answer

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

Question 11

A firm nearing bankruptcy has an incentive to issue more high risk debt.

Accepted Answer

A) True 
 B)False

Question 12

What is the relative tax advantage of debt? Assume that personal and corporate taxes are given by: TC = (corporate tax rate)= 21 percent; TpE = personal tax rate on equity income = 15 percent; and Tp = personal tax rate on interest income = 37 percent.

Accepted Answer

A) 0.94 
B) 1.16 
C) 1.35 
D) 0.86 
A) 0.94 
B) 1.16 
C) 1.35 
D) 0.86

Question 13

The value of a levered firm, given permanent debt level D, is Value of levered firm = Value of unlevered firm + (TC)(D). This assumes zero costs of financial distress.

Accepted Answer

A) True 
 B)False

Question 14

The trade-off theory of capital structure predicts that

Accepted Answer

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, especially at high debt ratios. 
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, especially at high debt ratios.

Question 15

Which of the following is not a potential result from financial distress?

Accepted Answer

A) Suppliers refuse to extend terms to the firm. 
B) Key employees leave the firm, fearing the firm won't last. 
C) The firm has difficulty issuing additional bonds. 
D) Due to interest tax shields, the firm's effective tax rate is very low. 
A) Suppliers refuse to extend terms to the firm. 
B) Key employees leave the firm, fearing the firm won't last. 
C) The firm has difficulty issuing additional bonds. 
D) Due to interest tax shields, the firm's effective tax rate is very low.

Question 16

In Miller's model, when the quantity (1 − TC)(1 − TpE)= (1 − Tp), then

Accepted Answer

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 firm should be financed by 100 percent equity. 
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 firm should be financed by 100 percent equity.

Question 17

The costs of financial distress depend on the:
I.probability of financial distress;
II.corporate and personal tax rates;
III.magnitude of costs encountered if financial distress occurs

Accepted Answer

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

Question 18

Explain the pecking order theory of capital structure.

Accepted Answer

This theory is based on the observation

Question 19

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

Accepted Answer

A) True 
 B)False

Question 20

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

Accepted Answer

A) True 
 B)False

Exam 18: How Much Should a Corporation Borrow

According to the trade-off theory of capital structure,

The main advantage of debt financing for a firm is: I.no SEC registration is required for bond issues; II.interest expenses are tax deductible; III.unlevered firms have higher value than levered firms

Compared to a firm with unlimited liability, the limited liability feature of common equity results in a

Discuss the 1995 results of Rajan and Zingales from the trade-off theory perspective.

When the costs of financial distress are included, the value of a levered firm is given by Value of levered firm = Value of unlevered firm + PV (tax shield)− PV (costs of financial distress).

The pecking order theory of capital structure implies that: I.high-risk firms will end up borrowing more; II.firms prefer internal finance; III.firms prefer debt to equity when external financing is required

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

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

A firm nearing bankruptcy has an incentive to issue more high risk debt.

What is the relative tax advantage of debt? Assume that personal and corporate taxes are given by: TC = (corporate tax rate)= 21 percent; TpE = personal tax rate on equity income = 15 percent; and Tp = personal tax rate on interest income = 37 percent.

The value of a levered firm, given permanent debt level D, is Value of levered firm = Value of unlevered firm + (TC)(D). This assumes zero costs of financial distress.

The trade-off theory of capital structure predicts that

Which of the following is not a potential result from financial distress?

In Miller's model, when the quantity (1 − TC)(1 − TpE)= (1 − Tp), then

The costs of financial distress depend on the: I.probability of financial distress; II.corporate and personal tax rates; III.magnitude of costs encountered if financial distress occurs

Explain the pecking order theory of capital structure.

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

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

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

What is the relative tax advantage of debt? Assume that personal and corporate taxes are given by: T_C = (corporate tax rate)= 21 percent; T_p_E = personal tax rate on equity income = 15 percent; and T_p = personal tax rate on interest income = 37 percent.

The value of a levered firm, given permanent debt level D, is Value of levered firm = Value of unlevered firm + (T_C)(D). This assumes zero costs of financial distress.

In Miller's model, when the quantity (1 − T_C)(1 − T_p_E)= (1 − T_p), then