Chapter 17 - Capital Structure: Limits to the Use of Debt

Chapter 17

Capital Structure: Limits to the Use of Debt

Multiple Choice Questions

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.

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Chapter 17 - Capital Structure: Limits to the Use of Debt

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

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Chapter 17 - Capital Structure: Limits to the Use of Debt

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.

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Chapter 17 - Capital Structure: Limits to the Use of Debt

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 A and B. E. Both B and C.

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 the above.

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