Question 1

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

Accepted Answer

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 theShareholders.
D)  management because if the ﬁrm defaults they will lose their jobs.
E)  None of the above.F) C) and D)
G) A) and B)

Question 2

The optimal capital structure has been achieved when the:

Accepted Answer

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.F) A) and B)
G) A) and C)

Question 3

The explicit costs, such as the legal expenses, associated with corporate default are classiﬁed as _____ costs.

Accepted Answer

A)  ﬂotation
B)  beta conversion
C)  direct bankruptcy
D)  indirect bankruptcy
E)  unleveredF) C) and D)
G) A) and D)

Question 4

Given the following information, leverage will add how much value to the unlevered ﬁrm per pound of debt?
Corporate tax rate: 30%
Personal tax rate on income from bonds: 20%
Personal tax rate on income from shares: 0%

Accepted Answer

A)  £0.125
B)  £0.472
C)  £0.528
D)  £0.825
E)  None of the above.F) C) and E)
G) A) and E)

Question 5

The Do-All-Right Marketing Research ﬁrm has promised payments to its bondholders that total £100.The company believes that there is a 85% chance that the cash ﬂow will be suﬃcient to meet theseclaims.However, there is a 15% chance that cash ﬂows will fall short, in which case total earnings areexpected to be £65.If the bonds sell in the market for £84, what is an estimate of the bankruptcycosts for Do-All-Right? Assume a cost of debt of 10%.

Accepted Answer

The expected amount bondholders receive ...

Question 6

You are the CEO of Cautious Care, a publicly listed home care company.As a result of a change in government regulations, you will soon be allowed to extend the services your company offers.You expect to increase your market share as well as your proﬁt margins.You schedule a talk with your CFO and discuss how you will ﬁnance the investments required for the company to use this great opportunity.What advice should your CFO give you?

Accepted Answer

Since the company's proﬁtability is expe...

Question 7

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:

Accepted Answer

A)  2.9%
B)  16.9%
C)  27.3%
D)  40.0%
E)  100%F) A) and E)
G) C) and D)

Question 8

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

Accepted Answer

A)  the ﬁrm will rank all projects and take the project which results in the highest expected valueOf the ﬁrm.
B)  bondholders expropriate value from shareholders by selecting high risk projects.
C)  shareholders expropriate value from bondholders by selecting high risk projects.
D)  the ﬁrm will always take the low risk project.
E)  Both A and B.F) A) and B)
G) None of the above

Question 9

In a Miller equilibrium, what type of investments do high tax bracket investors tend to hold?

Accepted Answer

A)  Bonds
B)  Stocks
C)  Debentures
D)  Both shares and bonds.
E)  Neither shares nor bonds.F) B) and E)
G) A) and C)

Question 10

$$\begin{array}{l}
\text { Consider an economy in which there are three groups of investors and no others. }\
\begin{array} { | l | l | l | } 
\hline & \text { Marginal tax rate } & \text { Personal wealth } \
\hline \text { Group } & \text { on bonds } & \text { (£ millions) } \
\hline \text { Plumbers } & 60 \% & 2,500 \
\hline \text { Doctors } & 50 \% & 700 \
\hline \text { Lawyers } & 40 \% & 100 \
\hline
\end{array}
\end{array}$$ There are no personal taxes on income from stocks.An investment is available that pays a tax-free 4%.The tax rate is 50%.Total corporate income before earnings and taxes (EBIT) is £224 million forever.What is the maximum debt-to-equity ratio for the economy as a whole?

Accepted Answer

The interest rate on debt = .04/(1-.5) =...

Question 11

The pecking order theory and the trade-off theory of optimal capital structure lead to different predictions:

Accepted Answer

A)  According to the trade-off theory, there is no target amount of leverage.
B)  According to the pecking order theory, proﬁtable ﬁrms use more debt.
C)  According to the trade-off theory, ﬁrms do not use internal funds to ﬁnance investments.
D)  According to the pecking order theory, tax rates have no effect on leverage.
E)  None of the above.F) B) and E)
G) A) and B)

Question 12

Which of the following is not empirically true when formulating capital structure policy?

Accepted Answer

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%.F) None of the above
G) A) and B)

Question 13

Which of the following industries would tend to have the highest leverage?

Accepted Answer

A)  Drugs
B)  Computer
C)  Paper
D)  Electronics
E)  Biological productsF) B) and E)
G) A) and E)

Question 14

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 _____.

Accepted Answer

A)  increases; increases; increases
B)  decreases; decreases; decreases
C)  increases; increases; decreases
D)  decreases; decreases; increases
E)  increases; decreases; decreasesF) B) and D)
G) C) and E)

Question 15

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.

Accepted Answer

A)  £120,000
B)  £162,948
C)  £258,537
D)  £263,080
E)  £332,143F) C) and E)
G) C) and D)

Question 16

Describe some of the sources of business risk and ﬁnancial risk.Do ﬁnancial decision makers have the ability to "trade off" one type of risk for the other?

Accepted Answer

Some of the observed variations in capit...

Question 17

Wigdor Manufacturing is currently all equity ﬁnanced, had EBIT of £2 million, and is in the 34% tax bracket.Louis, the company's founder, is the lone shareholder.Assume that all earnings are paid out as dividends.Now consider the fact that Louis must pay personal tax on the ﬁrm's cash ﬂow.Louis pays taxes on interest at a rate of 33%, but pays taxes on dividends at a rate of 28%. If the ﬁrm were to convert £4 million of equity into debt at a cost of 10%, calculate the total cash ﬂow to Louis after he pays personal taxes.Compare this to Louis' total cash ﬂow after personal taxes if the ﬁrm remains unlevered.

Accepted Answer

\[\begin{array} { | l | l | l | }
\hlin...

Question 18

Given the following information, leverage will add how much value to the unlevered ﬁrm per pound of debt?
Corporate tax rate: 34%
Personal tax rate on income from bonds: 20%
Personal tax rate on income from shares: 50%

Accepted Answer

A)  £-0.050
B)  £-0.188
C)  £0.367
D)  £0.588
E)  None of the above.F) D) and E)
G) C) and D)

Question 19

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

Accepted Answer

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

Question 20

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.

Accepted Answer

A)  £120,000
B)  £162,948
C)  £258,537
D)  £263,080
E)  £355,938F) A) and E)
G) All of the above

Exam 16: Capital Structure: Limits to the Use of Debt

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:

Correct Answer
verified

Which of the following industries would tend to have the highest leverage?

Correct Answer
verified

Which of the following is not empirically true when formulating capital structure policy?

Correct Answer
verified

Describe some of the sources of business risk and ﬁnancial risk.Do ﬁnancial decision makers have the ability to "trade off" one type of risk for the other?

Correct Answer
verified
Some of the observed variations in capit...
View Answer

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.

Correct Answer
verified

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

Correct Answer
verified

The pecking order theory and the trade-off theory of optimal capital structure lead to different predictions:

Correct Answer
verified

The explicit costs, such as the legal expenses, associated with corporate default are classiﬁed as _____ costs.

Correct Answer
verified

Correct Answer
verified
Since the company's proﬁtability is expe...
View Answer

Correct Answer
verified
\[\begin{array} { | l | l | l | }
\hlin...
View Answer

Correct Answer
verified
The interest rate on debt = .04/(1-.5) =...
View Answer

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

Correct Answer
verified

The optimal capital structure has been achieved when the:

Correct Answer
verified

In a Miller equilibrium, what type of investments do high tax bracket investors tend to hold?

Correct Answer
verified

Given the following information, leverage will add how much value to the unlevered ﬁrm per pound of debt? Corporate tax rate: 34% Personal tax rate on income from bonds: 20% Personal tax rate on income from shares: 50%

Correct Answer
verified

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

Correct Answer
verified

Correct Answer
verified
The expected amount bondholders receive ...
View Answer

Given the following information, leverage will add how much value to the unlevered ﬁrm per pound of debt? Corporate tax rate: 30% Personal tax rate on income from bonds: 20% Personal tax rate on income from shares: 0%

Correct Answer
verified

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 ___.

Correct Answer
verified

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.

Correct Answer
verified

Exam 16: Capital Structure: Limits to the Use of Debt

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:

Correct AnswerverifiedShow Answer

Which of the following industries would tend to have the highest leverage?

Correct AnswerverifiedShow Answer

Which of the following is not empirically true when formulating capital structure policy?

Correct AnswerverifiedShow Answer

Describe some of the sources of business risk and ﬁnancial risk.Do ﬁnancial decision makers have the ability to "trade off" one type of risk for the other?

Correct AnswerverifiedSome of the observed variations in capit...View AnswerShow Answer

Correct AnswerverifiedShow Answer

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

Correct AnswerverifiedShow Answer

The pecking order theory and the trade-off theory of optimal capital structure lead to different predictions:

Correct AnswerverifiedShow Answer

The explicit costs, such as the legal expenses, associated with corporate default are classiﬁed as _____ costs.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedSince the company's proﬁtability is expe...View AnswerShow Answer

Correct Answerverified\[\begin{array} { | l | l | l | } \hlin...View AnswerShow Answer

Correct AnswerverifiedThe interest rate on debt = .04/(1-.5) =...View AnswerShow Answer

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

Correct AnswerverifiedShow Answer

The optimal capital structure has been achieved when the:

Correct AnswerverifiedShow Answer

In a Miller equilibrium, what type of investments do high tax bracket investors tend to hold?

Correct AnswerverifiedShow Answer

Given the following information, leverage will add how much value to the unlevered ﬁrm per pound of debt? Corporate tax rate: 34% Personal tax rate on income from bonds: 20% Personal tax rate on income from shares: 50%

Correct AnswerverifiedShow Answer

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

Correct AnswerverifiedShow Answer

Correct AnswerverifiedThe expected amount bondholders receive ...View AnswerShow Answer

Given the following information, leverage will add how much value to the unlevered ﬁrm per pound of debt? Corporate tax rate: 30% Personal tax rate on income from bonds: 20% Personal tax rate on income from shares: 0%

Correct AnswerverifiedShow Answer

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 _____.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified
Some of the observed variations in capit...
View Answer

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified
Since the company's proﬁtability is expe...
View Answer

Correct Answer
verified
\[\begin{array} { | l | l | l | }
\hlin...
View Answer

Correct Answer
verified
The interest rate on debt = .04/(1-.5) =...
View Answer

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified
The expected amount bondholders receive ...
View Answer

Correct Answer
verified

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 ___.

Correct Answer
verified

Correct Answer
verified