Chapter 17-CF

When firms issue more debt, the present value of the tax shield on debt _____ while the present value of financial distress costs:

• decreases; decreases

• increases; increases.

• decreases; remains constant

• decreases; increases.

The free cash flow hypothesis states:

• that firms with greater free cash flow will pay more in dividends thereby reducing the risk of financial distress

• that firms with greater free cash flow should issue new equity to help minimize the wasting of resources by managers.

• that issuing debt requires interest and principal payments to be paid thereby reducing the potential of management to waste resources

• that firms with higher levels of free cash flow should reward their managers with bonuses

The pecking order states that firms should:

• always issue equity to avoid financial distress costs.

• issue new equity first.

• always issue debt then the market won't know when management thinks the security is overvalued.

• use internal financing first.

Which one of these best exemplifies “milking the property”?

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

• a firm with high financial distress paying additional dividends

• an all-equity firm repurchasing shares

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

Assume the corporate tax rate is 34 percent, the personal tax rate on interest income is 15 percent, and the personal tax rate on dividends is 10 percent. If the firm earns $5 per share in taxable income and pays out 40 percent of its earnings, how much will a shareholder receive in aftertax income?

• $1.188

• $1.232

• $1.782

• $1.232

A firm is currently valued at $175 in a boom and $110 in a recession. The chance of either economic state occurring is 50 percent. The firm owes $120 to its debt holders. What is the value of the firm to the shareholders in a recession?

• $22.50

• $55.00

• $27.50

• $0

According to the trade-off theory, firms should balance the tax benefits of debt with the costs of financial distress. What does this imply about a firm's capital structure?

• Firms should only issue debt when interest rates are low.

• Firms should avoid debt at all costs.

• Firms should aim for a mix of debt and equity to optimize their value.

• Firms should only use equity financing.

If a firm has a high level of retained earnings, what is the most likely implication for its financing decisions?

• The firm will rely heavily on external financing.

• The firm will issue more debt to leverage its retained earnings.

• The firm is likely to prefer internal financing over issuing new equity.

• The firm will distribute all retained earnings as dividends.

Conflicts of interest between stockholders and bondholders are known as

• financial distress costs.

• dealer costs.

• agency costs of debt

• agency costs of equity

One of the indirect costs of bankruptcy is the incentive for managers to take large risks. When following this strategy

• stockholders expropriate value from bondholders by selecting high-risk projects

• bondholders expropriate value from stockholders by selecting high-risk projects.

• the firm will rank all projects and select the project which results in the highest expected firm value.

• the firm will always select the lowest-risk project available.