Chapter 16
Short Description
econ...
Description
Chapter 16 Financial Leverage and Capital Structure Polic y
1. All else equal, higher financial leverage decreases a firms !rea"#even $%&'. Ans( False
Level( %asic
Su!)ect( Financial Leverage
'ype( 'ype( Concepts
*. %usiness ris" declines declines as the systematic systematic ris" of a firms assets increases. increases. Ans( False
Level( %asic
Su!)ect( %usiness +is"
'ype( 'ype( Concepts
. %usiness ris" is a positive function of the systematic ris" ris" of a firms assets. Ans( 'rue
Level( %asic
Su!)ect( %usiness +is"
'ype( 'ype( Concepts
-. &gnoring financial distress costs, !orroing !orroing money decreases the value of the firm !y increasing increasing the firms ta/ lia!ility. Ans( False
Level( %asic
Su!)ect( &nterest 'a/ 'a/ Shield
'ype( 'ype( Concepts
0. Suppose e ish to dra dra a graph graph illustrating 2 2 Proposition &&. &&. Let the vertical vertical a/is represent represent the cost of capital and the firms de!t#to#equity ratio represent the hori3ontal a/is4 then if the slope of the line representing the firms 5ACC 5ACC has a negative slope, e e must !e incorporating ta/es into the analysis. Ans( 'rue
Level( %asic
Su!)ect( 2 Proposition &&
'ype( 'ype( Concepts
6. irect !an"ruptcy costs are those costs that are directly associated associated ith !an"ruptcy, such as legal and administrative costs. Ans( 'rue
Level( %asic
Su!)ect( %an"ruptcy Costs
'ype( 'ype( Concepts
7. &ndirect !an"ruptcy costs include the costs costs of avoiding a !an"ruptcy filing incurred !y a financially distressed firm. Ans( 'rue
Level( %asic
Su!)ect( %an"ruptcy Costs
'ype( 'ype( Concepts
8. &t has !een o!served o!served that, hen firms get into financial trou!le, they often often find it difficult to attract and retain high#quality employees. 'he additional costs incurred in this situation ould !e considered direct !an"ruptcy costs. Ans( False
Level( %asic
Su!)ect( %an"ruptcy Costs
'ype( 'ype( Concepts
9. 5hen a firm files for !an"ruptcy, !an"ruptcy, the firm often must hire appraisers appraisers to determine the fair value value of the firms assets. 'his is an e/ample of a direct cost of !an"ruptcy. Ans( 'rue
Level( %asic
Su!)ect( %an"ruptcy Costs
'ype( 'ype( Concepts
1:. According to the static theory of capital capital structure, value#ma/imi3ing financial managers ill !orro !orro to the point here the firms !usiness ris" is )ust equal to its financial ris". Ans( False
Level( %asic
Su!)ect( Capital Structure 'heories
'ype( 'ype( Concepts
Copyright ; *::0 cne method of restructuring de!t involves composition, hich involves a reduction in the amount of the payment to !e made. Ans( 'rue
Level( %asic
Su!)ect( Agreements to Avoid Avoid %an"ruptcy
'ype( 'ype( Concepts
1. 'he use of personal personal !orroing to change the overall overall amount of financial leverage to hich the individual is e/posed is called( A? =omemade leverage. %? ivid ivideend recaptur ture. C? 'he 'he eig eight hted ed ave avera rage ge cos costt of capi capita tal. l. ? Priv Privat atee de!t de!t plac placeement ment.. $? A pri privi vile lege ged d su!s su!scr crip ipti tion on offe offerr. Ans( A
Level( %asic
Su!)ect( =omemade Leverage
'ype( 'ype( efinitions
1-. 'he proposition that the value of the firm is independent of its capital structure structure is called( A? 'he 'he Cap Capit ital al Ass sset et Pric Pricin ing g od odel el.. %? 2 2 Pro Propo posi siti tion on & @i @ith thou outt ta/e ta/es? s?.. C? 2 Propositio tion &&. ? 'he La of >ne Price. $? 'he 'he $ff $ffic icie ient nt ar ar"e "ets ts =y =ypoth pothes esis is.. Ans( %
Level( %asic
Su!)ect( 2 Proposition &
'ype( 'ype( efinitions
10. 'he proposition that the cost of equity is a positive linear function of capital structure structure is called( A? 'he 'he Cap Capit ital al Ass sset et Pric Pricin ing g od odel el.. %? 2 Pr Proposition &. &. C? 2 Propositio tion &&. ? 'he La of >ne Price. $? 'he 'he $ff $ffic icie ient nt ar ar"e "ets ts =y =ypoth pothes esis is.. Ans( C
Level( %asic
Su!)ect( 2 Proposition &&
'ype( 'ype( efinitions
16. 'he equity ris" derived derived from the firms operating activities activities is called ris". A? mar"et %? systematic C? e/trinsic ? !usiness $? financial Ans(
Level( %asic
Su!)ect( %usiness +is"
'ype( 'ype( efinitions
Copyright ; *::0 cf Capital Structure
'ype( 'ype( efinitions
*-. 'he legal proceeding proceeding for liquidating or reorgani3ing a firm operating in default is called a( a( A? 'ender offer. %? %an"ruptcy. C? erger. ? 'a"eover. $? Pro/y fight. Ans( %
Level( %asic
Su!)ect( %an"ruptcy
'ype( 'ype( efinitions
*0. A firm firm that has negative negative net net orth is said said to !e( A? $/pe $/peri rien enci cing ng a !usi !usine ness ss fai failu lure re.. %? &n leg legal !a !an"ruptcy tcy. C? $/pe $/peri rien enci cing ng tech technic nical al inso insolve lvency ncy.. ? $/pe $/peri rien enci cing ng acco accoun untin ting g inso insolv lven ency cy.. $? &n !an" !an"ru rupt ptcy cy reor reorga gani ni3a 3ati tion on.. Ans(
Level( %asic
Su!)ect( Accounting &nsolvency
'ype( 'ype( efinitions
*6. 'he complete termination of the firm as a going !usiness concern is called a . A? merger %? repurchase progr ogram C? liquidation ? reorgani3ation $? divestiture Ans( C
Level( %asic
Su!)ect( Liquidation
'ype( 'ype( efinitions
Copyright ; *::0 cn Assets
'ype( 'ype( efinitions
1. 'he cost of equity capital, !ased on 2 Proposition &&, &&, can !e defined defined as( A? + $ + D @+ A # + ? @E$?. %? + $ + A D @+ A # + ? @$E?. C? + $ + A D @+ A # + ? @E$?. ? + $ + A D @+ # + A? @$E?. $? + $ + # @+ # + A? @E$?. Ans( C
Level( %asic
Su!)ect( 2 Proposition &&
'ype( 'ype( efinitions
Copyright ; *::0 cf Capital Structure
'ype( 'ype( efinitions
0. 'he option of "eeping "eeping a financially distressed firm as an operating concern concern is called a@n?( a@n?( A? Liquidation. %? +eorgani3ation. C? Acquisition. ? erger. $? 'echnica ical so solvency. Ans( %
Level( %asic
Su!)ect( +eorgani3ation
'ype( 'ype( efinitions
6. 'he procedure procedure for liquidating liquidating a corporation corporation is outlined outlined in( A? 'he 'he %an" %an"ru rupt ptcy cy and and &ns &nsol olve venc ncy y Act Act.. %? 'he %A Act. C? 'he 'he Ca Canad nadian ian Cons Consti titu tuti tion on.. ? Chapter 11. $? 'he 'he Smal Smalll %us %usin ines esss +efo +eform rm Act. ct. Ans( A
Level( %asic
Su!)ect( %an"ruptcy and &nsolvency Act
Copyright ; *::0 c$S not correctly correctly ran" the priority of claims of the parties to a corporate !an"ruptcyH @+an" from strongest to ea"est. ? A? 5ages 5ages and salari salaries4 es4 consum consumer er claim claims4 s4 unsec unsecure ured d credi creditor torss %? Contri! Contri!utio utions ns to employ employee ee !enefi !enefitt plans4 plans4 consum consumer er claims claims44 common common stoc"h stoc"holde olders rs C? f $quity
'ype( 'ype( Pro!lems
1:8. +G &nc. has has an asset !eta of :.90. &ts current current capital structure is 6:M de!t, -:M equity. 5hat is the firms equity !etaH &gnore ta/es. A? :.8: %? 1.*- C? 1.08 ? 1.870 $? *.70 Ans( $
Level( %asic
Su!)ect( $quity %eta
'ype( 'ype( Pro!lems
1:9. Suppose a firm issues perpetual de!t ith a face and mar"et value of 0,::: and a coupon rate of 1*M. &f the firm is su!)ect to a -:M ta/ rate and the appropriate discount rate is 1:M, hat is the present value of the interest ta/ shieldH A? 1,667 %? *,::: C? *,-:: ? ,6:: $? 6,::: Ans( C
Level( %asic
Su!)ect( Present Present Ialue Ialue >f 'a/ 'a/ Shield
'ype( 'ype( Pro!lems Pro!lems
11:. An unlevered firm has afterta/ net net income 1*0,:::. 'he unlevered cost of capital is 1M and the corporate ta/ rate is -M. -M. 5hat is the value of this firmH firmH A? 09-,1:* %? 6-,610 C? 7*9,60? 961,08 $? 1,:01,091 Ans(
Level( %asic
Su!)ect( Ialue Ialue >f An Bnlevered Firm
'ype( 'ype( Pro!lems Pro!lems
Copyright ; *::0 cf Capital
'ype( 'ype( Pro!lems
116. A firm has has an unlevered cost of capital capital of 1:M, a cost of de!t de!t of 9M, and a ta/ rate rate of -M. &f it desires a cost of equity of 1-M, hat is its target de!tEequity ratioH A? *.-9 %? .89 C? -.68 ? 0.1$? 6.:6 Ans( $
Level( %asic
Su!)ect( Levered Cost >f $quity
'ype( 'ype( Pro!lems
117. 'he %rassy Co. has e/pected $%&' $%&' 91:, an unlevered cost cost of capital of 1*M, and de!t ith a face and mar"et value of *,::: paying an 8.0M annual coupon. &f the ta/ rate is -M, hat is the 5ACC 5ACC of %rassy Co. H A? 1:.06M %? 11.1*M C? 1.*0M ? 1.6-M $? 1-.-0M Ans( A
Level( %asic
Su!)ect( 5eighted 5eighted Average Average Cost >f Capital
'ype( 'ype( Pro!lems Pro!lems
118. f Capital
'ype( 'ype( Pro!lems Pro!lems
Bse the folloing to anser questions 119#1*( Cu Current cap. structure As Assets e!t $quity Share price Shares outstanding %ond coupon rate
Proposed cap. structure 10 million 10 million : 6 million 10 million 9 million *0.:: **.0: 6::,::: HHH EA 8M
Copyright ; *::0 cf $quity 5ith 'a/es 'a/es
'ype( 'ype( Pro!lems Pro!lems
11. 'he pro)ected $%&' of a firm is ::,:::. 'he firm firm currently has 1::,::: shares shares of common stoc" outstanding at a value of 18 per share. 'he firm has no de!t. %y ho much ill the +>$ change if the firm !orros 6::,::: at 8M interest and uses the funds to repurchase shares of stoc" at the mar"et priceH &gnore ta/es. A? #*.67M %? 1.67M C? *.M ? -.M $? 0.67M Ans(
Level( &ntermediate
Su!)ect( Capital Structure
'ype( 'ype( Pro!lems
1*. AA, &nc. currently has *:,::: shares shares of stoc" outstanding at a mar"et value of -: a share. share. 'he firm is currently 1::M financed ith equity. AA is considering a restructuring hich ill include issuing -::,::: of !onds at par value ith i th a coupon rate of 6M. 5hat is i s the !rea"#even $%&'H A? 1*,::: %? *-,::: C? 6,::: ? -8,::: $? 6:,::: Ans(
Level( &ntermediate
Su!)ect( %rea"#$ven $!it
'ype( 'ype( Pro!lems
Copyright ; *::0 cne ould hope that the responses to this question reflect these aspects of the i ssue, as ell as the !asic mechanics involved. Level( Challenge
Su!)ect( 2 Proposition &
'ype( 'ype( $ssays
10. escri!e some of the sources of !usiness ris" and financial ris". o financial decision ma"ers have the a!ility to Otrade offO one t ype of ris" for the otherH Ans( Students should intuitively recogni3e that some of the o!served variation in capital structures across industries, for e/ample, reflect differences in the nature of the i ndustries themselves4 i.e., !usiness ris". Similarly, intuition ould suggest suggest that firms ith large capital requirements requirements and sta!le cash flos @e.g., electric utilities? are more li"ely to !e illing to raise funds via large amounts of !orroing. Alternatively, firms ith loer tangi!le asset needs and highly uncertain cash flos @e.g., small softare companies? are more li"el y to employ equity. Level( Challenge
Su!)ect( 2 Propositions
'ype( 'ype( $ssays
10-. &n each of the theories of capital structure, the cost of equity rises as the amount of de!t increases. increases. So hy dont financial managers use as little litt le de!t as possi!le to "eep the cost of equity donH After all, isnt the goal of the firm to ma/imi3e share value @and minimi3e shareholder costs?H Ans( 'his question requires students students to differentiate differentiate !eteen the cost of equity and and the eighted average cost of capital. &n fact, it gets to the essence of capital structure theory( the firm trades off higher equity costs for loer de!t costs. 'he shareholders !enefit @to a point, according to the static theory? !ecause their investment in the firm is leveraged, enhancing the return on their investment. 'hus, even though the cost of equity rises, the overall cost of capital declines @again, up to a point according to the static theory? and firm value rises. Level( Challenge
Su!)ect( Cost >f $quity
'ype( 'ype( $ssays
100. According to the capital structure theories e e/amined, a firm firm !enefits !y having having de!t since the interest e/pense is deducti!le for ta/ purposes, creating an interest ta/ shield?.'he interest ta/ shield, on the other hand, increases in value the higher the coupon rate on the de!t and the higher the ta/ rate? &gnoring financial distress costs, shouldnt the firm then choose to pay as high hi gh a coupon rate as possi!leH Ans( 'his odd question challenges the students to differentiate differentiate !eteen ta/ !enefits and after#ta/ costs. 'he interest ta/ shield measures the !enefits of having de!t, !ut ignores the cost side? 5hat matters to the firm is the 5ACC, 5ACC, hich is minimi3ed !y adding adding lo#cost de!t to the mi/. As de!t costs rise, rise, the after#ta/ cost of de!t rises, the 5ACC 5ACC rises, and the !enefits of de!t decline. Level( Challenge
Su!)ect( 'a/es 'a/es And &nterest Costs
'ype( 'ype( $ssays
Copyright ; *::0 c
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