Test for Chapter 17

The Supply Depot is considering issuing $1 million in bonds but their financial staff has advised that if they do, the value of the firm will decrease. Given this advice, you know the staff believes the firm

• will realize greater tax benefits by issuing equity securities

• wants to issue too few bonds to obtain the most benefit from debt

• is at, or has exceeded, its optimal debt-equity ratio

• currently is all-equity financed and adding debt will cause a decrease in firm value

• will suffer from a decrease in its WACC if the bonds are issued

Which one of these represents a difference between business entities in Japan and in the United States?

• Lenders in Japan frequently also take ownership positions in firms to which they lend

• Debt-equity ratios tend to be higher in the U.S. than they are in Japan

• There tends to be greater agency issues between stockholders and bondholders in Japan as compared to the U.S

• The debt-equity ratios for firms in Japan and in the U.S. tend to be relatively equal

• Bondholders in Japan are prohibited from also being shareholders in the same firm

In a world with taxes and financial distress, when a firm is operating with the optimal capital structure the

• weighted average cost of capital will be maximized

• firm will be all-equity financed

• required return on assets will be at its maximum point

• overall benefits of debt have all been realized

• debt-equity ratio will be minimized

Ignore financial distress costs. When [(1 −T_C) × (1 −T_S) = (1 −T_B)], then firms

• discover that both dividends and interest payments are non-deductible business expenses

• tend to be indifferent between issuing debt or issuing equity

• need to maintain a debt-equity ratio of .5

• should be all-equity financed

• can reduce their taxes by increasing their dividend payouts

Which one of these lowers cash flows?

• Increased sales due to an improved economy

• A decrease in the interest rate charged on debt

• Decreased costs

• Decreased use of leverage

• The associated costs of bankruptcy

Corporations in the U.S., as compared to other countries, tend to

• have a median leverage ratio that's equal to the average international median leverage ratio

• underutilize debt

• have relatively high leverage ratios due to the tax benefits gained

• rely less on equity financing than they should

• have extremely high debt-equity ratios

Conflicts of interest between stockholders and bondholders are known as

• financial distress costs

• dealer costs

• trustee costs

• underwriting costs

• agency costs

One of the indirect costs of bankruptcy is the incentive toward underinvestment. Underinvestment generally would result in

• bondholders contributing the full amount of any new investment, but both stockholders and bondholders sharing in the benefits of those investments

• the firm selecting all projects with positive NPVs

• shareholders making decisions based on the best interests of the bondholders

• the firm turning down positive NPV projects that would clearly be accepted if the firm were all-equity financed

• the firm accepting more projects than it would if the probability of bankruptcy was ignored

Which one of these best exemplifies "milking the property"?

• A firm demanding a premium to be acquired without a proxy fight

• An all-equity firm repurchasing shares

• A firm paying a premium to acquire a competitor

• A firm with high financial distress paying additional dividends

• A firm with high financial distress using expected dividends to repay debt

Assuming the interest on the debt is fully tax deductible, when rms issue more debt, the present value of the tax shield on debt _____ while the present value of the financial distress costs _____

• increases; increases

• decreases; increases

• decreases; remains constant

• decreases; decreases

• increases; remains constant