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

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 A and C. E. Both B and C.

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 the above.

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

36. Growth opportunities _______ the _____ of debt financing. A. increase; advantage B. decrease; advantage C. decrease; disadvantage D. Both A and C E. None of the above

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 the above.

39. In Miller's 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.

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

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 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 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 the above.

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

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

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