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

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.

Difficulty level: Medium Topic: PECKING ORDER Type: CONCEPTS

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

Difficulty level: Medium

Topic: GROWTH OPPORTUNITIES Type: CONCEPTS

37. Which of the following industries would tend to have the highest leverage? A. Drugs B. Computer C. Paper

D. Electronics

E. Biological products

Difficulty level: Easy

Topic: LEVERAGE IN PRACTICE Type: CONCEPTS

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

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.

Difficulty level: Medium Topic: PERSONAL TAXES Type: CONCEPTS

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.

Difficulty level: Medium Topic: PERSONAL TAXES Type: CONCEPTS

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.

Difficulty level: Medium Topic: PERSONAL TAXES Type: CONCEPTS

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

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

[0.5($35) + 0.5 ($20)]/1.1 = $27.5/1.1 = $25

Difficulty level: Medium Topic: VALUE OF DEBT Type: PROBLEMS

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%

($35/$25) -1 = .40 = 40%

Difficulty level: Medium

Topic: RETURN TO BOND HOLDERS Type: PROBLEMS

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

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.

Rb = .06/(1 - .3) = .06/.7 = .0857 = 8.57%

Difficulty level: Medium

Topic: PRE-TAX RETURN ON BONDS Type: PROBLEMS

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%

WACC = [(1.0 ? 1.6) ? .11] + [(.6 ? 1.6) ? .07] = .095; .095 = .5RE + (.5 ? .07); RE = .12 = 12%

Difficulty level: Challenge

Topic: WEIGHTED AVERAGE COST OF CAPITAL Type: PROBLEMS

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