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

Chapter 17 Capital Structure: Limits to the Use of Debt Answer Key

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

Difficulty level: Easy

Topic: DIRECT BANKRUPTCY COSTS Type: DEFINITIONS

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

Difficulty level: Easy

Topic: INDIRECT BANKRUPTCY COSTS Type: DEFINITIONS

17-21

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

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

Difficulty level: Easy

Topic: FINANCIAL DISTRESS COSTS Type: DEFINITIONS

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.

Difficulty level: Easy

Topic: FINANCIAL DISTRESS COSTS Type: DEFINITIONS

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.

Difficulty level: Easy Topic: BANKRUPTCY Type: DEFINITIONS

17-22

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

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.

Difficulty level: Easy

Topic: CAPITAL STRUCTURE Type: DEFINITIONS

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.

Difficulty level: Easy

Topic: CAPITAL STRUCTURE Type: DEFINITIONS

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

Difficulty level: Medium

Topic: OPTIMAL CAPITAL STRUCTURE Type: CONCEPTS

17-23

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.

Difficulty level: Medium

Topic: OPTIMAL CAPITAL STRUCTURE Type: CONCEPTS

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)

Difficulty level: Medium

Topic: OPTIMAL CAPITAL STRUCTURE Type: CONCEPTS

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.

Difficulty level: Easy

Topic: OPTIMAL CAPITAL STRUCTURE Type: CONCEPTS

17-24