Corporate Finance: Core Principles & Apps, 5e (Ross)
Chapter 15 Capital Structure: Limits to the Use of Debt
1) Which one of these represents an indirect cost of financial distress?
A) Court fees paid to a bankruptcy court
B) Legal fees paid to bankruptcy attorneys
C) Additional accounting fees incurred by a firm in preparation for a liquidation
D) A firm’s supplier requiring payment in cash rather than offering its normal credit terms
E) The expense incurred from hiring a consultant to evaluate a firm’s dissolution options
2) In principle, a firm becomes bankrupt when
A) its equity value falls to zero.
B) a lender refuses to lend any additional funds to the firm.
C) its current ratio is less than one.
D) it is one day late paying a payment to a creditor.
E) its debt exceeds its equity.
3) The costs of avoiding a bankruptcy filing by a financially distressed firm are classified as
________ costs.
A) indirect bankruptcy
B) direct bankruptcy
C) financial solvency
D) capital structure
E) flotation
4) The explicit costs, such as the legal expenses, associated with corporate default are classified as
________ costs.
A) unlevered
B) beta conversion
C) direct bankruptcy
D) indirect bankruptcy
E) flotation
5) 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) financial distress
E) indirect bankruptcy
6) Which one of the following statements concerning bankruptcy is correct?
A) Bondholders have a greater incentive than stockholders to keep a firm from filing for
bankruptcy.
B) An indirect cost of bankruptcy is the loss of key employees.
C) Bankruptcy is sometimes used as a means to increase payroll costs.
D) The assets of a firm tend to increase in value when a firm is in financial distress.
E) The administrative costs incurred in a bankruptcy are considered indirect bankruptcy costs.
7) Indirect bankruptcy costs
A) effectively limit the amount of equity a firm issues.
B) serve as an incentive to increase the financial leverage of a firm.
C) tend to increase as the debt-equity ratio decreases.
D) include the costs incurred by a firm as it tries to avoid seeking bankruptcy protection.
E) include the legal and accounting fees incurred during the bankruptcy process.
8) 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.
9) Conflicts of interest between stockholders and bondholders are known as
A) trustee costs.
B) financial distress costs.
C) dealer costs.
D) agency costs.
E) underwriting costs.
10) Which one of these statements most applies to a firm that is suffering from financial distress?
A) Bondholders will desire high risk projects in order to protect their investment.
B) Stockholders will increase their investment in the firm to protect their current investment.
C) Stockholders will generally prefer low-risk over high-risk projects.
D) Managers will tend to lower dividends in an effort to protect shareholder value.
E) Stockholders will bear the cost of selfish investment strategies through higher interest
payments.
11) Which one of these actions by a firm is an example of milking the property? Assume the firm is
in a period of financial distress.
A) Repaying a bond that matured
B) Paying the semiannual bond interest
C) Paying an extra dividend
D) Cutting a regular dividend
E) Paying a regular dividend
12) Which one of these best describes the relationship between bondholders and stockholders at a
time when it appears the firm may be facing increased financial distress?
A) Stockholders have an incentive to underinvest in new projects to the detriment of bondholders.
B) Both parties tend to work together for the common good of the firm.
C) Both bondholders and stockholders will encourage the firm to take on new high risk projects.
D) Bondholders will tend to lower their required rate of interest so the firm can afford additional
financing until its financial status improves.
E) Bondholders tend to milk the property at the expense of stockholders.
13) The protective covenants contained within a loan agreement
A) impose restrictions on the lender.
B) are designed to protect the borrower’s shareholders.
C) increase the borrower’s flexibility.
D) tend in increase the bond’s interest rate.
E) can increase the value of the borrowing firm.
14) Which of the following are common loan covenants? Assume each item applies only during
the term of the loan.
I. Limit on future borrowing
II. Requirement that the borrower maintains a minimum stated level of net working capital
III. Limit on any sales or switches of assets
IV. Limit on the amount of dividends that can be paid
A) I and IV only
B) II and III only
C) I, III, and IV only
D) I, II, and III only
E) I, II, III, and IV
15) The value of a firm is maximized when the
A) weighted average cost of capital is minimized.
B) levered cost of capital is maximized.
C) tax rate is zero.
D) cost of equity is maximized.
E) debt-equity ratio is minimized.
16) The optimal capital structure has been achieved when the
A) weight of equity is equal to the weight of debt.
B) debt-equity ratio selected results in the lowest possible weighted average cost of capital.
C) firm is totally financed with debt.
D) debt-equity ratio is such that the cost of debt exceeds the cost of equity.
E) cost of equity is maximized.
17) Which of these will occur in a world with taxes and financial distress when a firm is operating
at its optimal capital structure?
I. The debt-equity ratio will 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 will equal 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
18) The optimal capital structure will tend to include more debt for firms with
A) less taxable income.
B) lower probability of financial distress.
C) substantial tax shields from other sources.
D) the lowest marginal tax rate.
E) the highest depreciation deductions.
19) 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) maximizes; maximizes
C) minimizes; maximizes
D) maximizes; minimizes
20) The optimal capital structure of a firm
A) will remain constant over time unless the firm makes an acquisition.
B) is unaffected by changes in the financial markets.
C) will be the same for all firms in the same industry.
D) places more emphasis on the operations than on the financing of the firm.
E) will vary over time as taxes and market conditions change.
21) In a world with corporate taxes, MM theory implies that that all firms should
A) maintain a constant value.
B) decrease in value as the leverage of the firm increases.
C) choose an all-debt capital structure.
D) select the capital structure that maximizes the firm’s WACC.
E) select the capital structure that equates the marginal cost of debt with the marginal benefits.
22) Which one of these relationships will exist if a firm is operating under its optimal capital
structure?
A) The net present value of the firm will equal zero.
B) The firm’s cost of capital will equal the risk-free rate.
C) The present value of the financial distress costs will equal the present value of the tax shield on
debt.
D) The value of the firm will equal the maximum value obtainable according to the MM theories.
E) The firm will be financed with equal amounts of long-term debt and equity.
23) Which one of these statements is correct for a levered firm?
A) An increase in tax rates will decrease the value of the firm.
B) An increase in financial distress costs increases the value of a firm.
C) To obtain its maximum value, a firm should select an all-equity capital structure.
D) The value of a firm is maximized when its cost of capital is also maximized.
E) The optimal level of debt for a firm results in the value of that firm being maximized.
24) Which one of these is a payment of a nonmarketed claim on a firm’s cash flows?
A) Dividend payment
B) Principal repayment of a bond
C) Repurchase of stock
D) Payment of a customer’s liability claim
E) Payment of interest due on a bond
25) Which one of these statements is correct?
A) Only the nonmarketed claims of a firm can be bought and sold.
B) An increase in a firm’s marketed claims will increase the total value of a firm.
C) The total value of a firm is independent of the firm’s cash flows.
D) Managers try to maximize both marketed and nonmarketed claims in order to maximize total
firm value.
E) The value of a firm’s marketed claims can change with changes in the firm’s capital structure.
26) A valuable firm will tend to:
A) see its stock price increase if it issues debt beyond its optimal debt level.
B) issue more debt than a less valuable firm of comparable size.
C) reduce its debt level as a positive signal for the firm.
D) issue debt, but only on a temporary basis purely to fool investors regarding the firm’s value.
E) see its stock price increase when it announces an exchange offer that decreases its leverage.
27) Which one of the following is true?
A) A firm with low anticipated profits will likely take on a high level of debt.
B) Investors will generally view an increase in leverage as a positive sign of the firm’s value.
C) Rational investors are likely to infer a higher firm value if a firm is all-equity financed.
D) Rational firms raise debt levels when profits are expected to decline.
E) High-growth firms with future positive net present value projects tend to have high levels of
debt.
28) Issuing debt instead of new equity in a closely held firm more likely causes owner-managers to
A) work harder than they would if equity had been issued.
B) consume more perquisites because the cost is passed on to the debtholders.
C) enjoy more leisure time than they would with an equity issue.
D) accept more unprofitable projects.
E) shirk their duties as they have less capital at risk.
29) The optimal debt-equity ratio tends to
A) remain constant when agency costs of equity are considered.
B) support the all-debt capital structure.
C) increase when agency costs of equity exist.
D) be directly related to the costs of financial distress.
E) decrease as the tax rate increases.
30) The free cash flow hypothesis supports
A) decreasing stockholder dividends to retain more cash within the firm.
B) reducing a firm’s level of debt to reduce the amount of cash used to pay interest.
C) increasing the debt portion of a firm’s capital structure to increase firm value.
D) hiring managers with little or no stock ownership in the firm.
E) the idea that firms with high levels of free cash flow are more apt to make good acquisitions
than firms with low levels.
31) The pecking order theory identifies two rules. The first rule is to
A) issue convertible debt prior to straight debt to save funds.
B) use short-term debt to its maximum available limit prior to issuing long-term debt.
C) issue new equity first in order to retain internal funds and avoid interest costs.
D) issue new debt prior to new equity.
E) use internal financing prior to external financing.
32) The pecking order theory states that when external funds are required, a firm should
A) refund all monies pulled from internal sources with external funds.
B) only issue equity securities after the firm’s debt capacity is reached.
C) never issue any convertible securities.
D) issue convertible bonds prior to straight bonds.
E) limit its debt-equity ratio to no more than 0.5.
33) Which one of these statements is a correct implication of the pecking order theory?
A) External financing should be limited to debt issues.
B) The target debt level occurs when the marginal benefit of debt equals the marginal cost of debt.
C) Companies like financial slack so they can reduce their external capital needs.
D) Internally funded projects lower the market value of equity.
E) Profitable firms use more debt.
34) Corporations in the U.S. tend to
A) have extremely high debt-equity ratios.
B) rely less on equity financing than they should.
C) minimize taxes.
D) underutilize debt.
E) rely more heavily on bonds than stocks as the major source of financing.
35) In general, the capital structures of U.S. firms:
A) tend to overweight debt in relation to equity.
B) employ less debt when the firm requires large amounts of tangible assets.
C) are constant over time on a firm-by-firm basis.
D) tend to be those that maximize the use of each firm’s available tax shelters.
E) vary significantly across industries.