Corporate Finance, 12e (Ross)

Chapter 17 Capital Structure: Limits to the Use of Debt

1) Which one of these lowers cash flows?

A) Decreased use of leverage
B) Decreased costs
C) Increased sales due to an improved economy
D) The associated costs of bankruptcy
E) A decrease in the interest rate charged on debt

Answer: D
Difficulty: 1 Easy
Section: 17.1 Costs of Financial Distress
Topic: Financial distress
Bloom's: Remember
AACSB: Reflective Thinking
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2) The explicit costs, such as the legal expenses, associated with corporate default are classified
as:
A) debt flotation costs.
B) beta conversion costs.
C) direct costs of financial distress.
D) indirect bankruptcy costs.
E) unlevered costs of capital.

Answer: C
Difficulty: 1 Easy
Section: 17.2 Description of Financial Distress Costs
Topic: Bankruptcy
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3) What is the estimated direct cost of financial distress as a percentage of the market value of a
firm as estimated by White, Altman, and Weiss?
A) 3 percent
B) 5 percent
C) 8 percent
D) 1 percent
E) 10 percent

Answer: A
Difficulty: 1 Easy
Section: 17.2 Description of Financial Distress Costs
Topic: Bankruptcy
Bloom's: Remember
AACSB: Reflective Thinking
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4) Which one of the following is a direct, rather than an indirect, cost of financial distress?
A) Key employee leaving for another job due to concerns over job security given the company's
financial status
B) Loss of a key supplier due to late payments to that supplier
C) Fees paid to financial advisors related to bankruptcy matters
D) Loss of customers due to concerns the company will close
E) Money spent to send a mailing to customers dispelling any and all financial distress concerns
about the company

Answer: C
Difficulty: 1 Easy
Section: 17.2 Description of Financial Distress Costs
Topic: Bankruptcy
Bloom's: Understand
AACSB: Reflective Thinking
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5) 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.

Answer: D
Difficulty: 1 Easy
Section: 17.2 Description of Financial Distress Costs
Topic: Agency costs and problems
Bloom's: Understand
AACSB: Reflective Thinking

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6) One of the indirect costs of bankruptcy is the effect that a potential bankruptcy has on the
firm's decisions. The general result is that:
A) the firm will rank all projects and select the project which results in the highest expected firm
value.
B) bondholders expropriate value from stockholders by selecting high-risk projects.
C) stockholders expropriate value from bondholders by selecting high-risk projects.
D) the firm will always select the lowest-risk project available.
E) the firm will select only all-equity financed projects.

Answer: C
Difficulty: 1 Easy
Section: 17.2 Description of Financial Distress Costs
Topic: Agency costs and problems
Bloom's: Understand
AACSB: Reflective Thinking
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7) One of the indirect costs of bankruptcy is the incentive toward underinvestment.

Underinvestment generally would result in:
A) the firm selecting all projects with positive NPVs.
B) the firm turning down positive NPV projects that would clearly be accepted if the firm were
all-equity financed.
C) bondholders contributing the full amount of any new investment, but both stockholders and
bondholders sharing in the benefits of those investments.
D) shareholders making decisions based on the best interests of the bondholders.
E) the firm accepting more projects than it would if the probability of bankruptcy was ignored.

Answer: B
Difficulty: 1 Easy
Section: 17.2 Description of Financial Distress Costs
Topic: Agency costs and problems
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8) Which one of these best exemplifies "milking the property"?
A) A firm paying a premium to acquire a competitor
B) A firm demanding a premium to be acquired without a proxy fight
C) A firm with high financial distress paying additional dividends
D) An all-equity firm repurchasing shares
E) A firm with high financial distress using expected dividends to repay debt

Answer: C
Difficulty: 1 Easy
Section: 17.2 Description of Financial Distress Costs
Topic: Agency costs and problems
Bloom's: Understand
AACSB: Reflective Thinking
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9) Shareholders sometimes pursue selfish strategies when financial distress is present. These
actions generally result in:
A) no action by debtholders since these are shareholder concerns.
B) agency costs to bondholders.
C) investments with risks similar to those of the current firm.
D) undertaking scale-enhancing projects.
E) lower agency costs, as shareholders have more control over the firm's assets.

Answer: B
Difficulty: 1 Easy
Section: 17.2 Description of Financial Distress Costs
Topic: Agency costs and problems
Bloom's: Understand
AACSB: Reflective Thinking
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10) Bondholders tend to offset the effects of selfish strategies implemented by shareholders by:
A) restructuring their loans to provide additional time to the firm to make repayment.
B) subordinating their bankruptcy position to the shareholders.
C) agreeing to reduce the outstanding principal balances on their loans.
D) agreeing to reduce the interest rate on existing loans.
E) increasing the interest rate on monies loaned to the firm.

Answer: E
Difficulty: 1 Easy
Section: 17.2 Description of Financial Distress Costs
Topic: Bankruptcy
Bloom's: Understand
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11) Covenants restricting additional borrowings primarily protect the:
A) shareholders' residual interests in the firm.
B) debtholders from the added risk of dilution of their claims.
C) debtholders from changes in market interest rates.
D) managers by avoiding agency costs.
E) shareholders from agency costs.

Answer: B
Difficulty: 1 Easy
Section: 17.3 Can Costs of Debt be Reduced?
Topic: Indenture provisions
Bloom's: Understand
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12) If a firm issues debt and includes protective covenants in the indenture then the firm's debt
will probably be issued at ________ similar debt without the covenants.
A) a variable interest rate rather than the fixed rate paid on
B) a lower interest rate than
C) a significantly higher interest rate than
D) an interest rate equal to that of
E) a slightly higher interest rate than

Answer: B
Difficulty: 1 Easy
Section: 17.3 Can Costs of Debt be Reduced?
Topic: Indenture provisions
Bloom's: Understand
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13) Which one of these is most related to a positive covenant?

A) Limiting the amount of the firm's dividends
B) Avoiding a merger while a debt remains unpaid
C) Furnishing financial statements to the firm's lenders
D) Not issuing any additional long-term debt
E) Not selling any major assets without lender approval

Answer: C
Difficulty: 1 Easy
Section: 17.3 Can Costs of Debt be Reduced?
Topic: Indenture provisions
Bloom's: Understand
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14) Suppose a potential bondholder requires an indenture agreement to include a limit on
dividend distributions by the bond's issuer and also a restriction on the sale of the issuer's assets.
In this case, the bondholder is most likely concerned about:
A) shareholder claims being diluted.
B) shareholders claiming all of the residual profits of the firm.
C) increasing interest rates.
D) shareholders transferring firm assets to themselves.
E) shareholders earning a higher return on their investment in the firm than the bondholders earn
on their debt.

Answer: D
Difficulty: 1 Easy
Section: 17.3 Can Costs of Debt be Reduced?
Topic: Indenture provisions
Bloom's: Understand
AACSB: Reflective Thinking
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15) Which one of these represents a difference between business entities in Japan and in the
United States?
A) Lenders in Japan frequently also take ownership positions in firms to which they lend.
B) Debt-equity ratios tend to be higher in the U.S. than they are in Japan.
C) There tends to be greater agency issues between stockholders and bondholders in Japan as
compared to the U.S.
D) Bondholders in Japan are prohibited from also being shareholders in the same firm.
E) The debt-equity ratios for firms in Japan and in the U.S. tend to be relatively equal.

Answer: A
Difficulty: 1 Easy
Section: 17.3 Can Costs of Debt be Reduced?
Topic: Indenture provisions
Bloom's: Understand
AACSB: Reflective Thinking
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16) Which one of these parties holds a marketable claim on a firm's assets?
A) Customers
B) Employees
C) Bondholders
D) Internal Revenue Service
E) State tax authorities

Answer: C
Difficulty: 1 Easy
Section: 17.4 Integration of Tax Effects and Financial Distress Costs
Topic: Marketed and nonmarketed claims
Bloom's: Understand
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17) The value of a firm is maximized when the:

A) cost of equity is maximized.
B) tax rate is zero.
C) levered cost of capital is maximized.
D) weighted average cost of capital is minimized.
E) debt-equity ratio is minimized.

Answer: D
Difficulty: 1 Easy
Section: 17.4 Integration of Tax Effects and Financial Distress Costs
Topic: Capital structure and firm valuation
Bloom's: Understand
AACSB: Reflective Thinking
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18) The optimal capital structure has been achieved when the:
A) debt-equity ratio is equal to 1.
B) weight of equity is equal to the weight of debt.
C) cost of equity is maximized given a pretax cost of debt.
D) debt-equity ratio is such that the cost of debt exceeds the cost of equity.
E) present value of the financial distress costs equals the present value of the tax shield on debt.

Answer: E
Difficulty: 1 Easy
Section: 17.4 Integration of Tax Effects and Financial Distress Costs
Topic: Capital structure and firm valuation
Bloom's: Understand
AACSB: Reflective Thinking
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19) In a world with taxes and financial distress, when a firm is operating with the optimal capital
structure the:
A) debt-equity ratio will be minimized.
B) weighted average cost of capital will be maximized.
C) firm will be all-equity financed.
D) required return on assets will be at its maximum point.
E) overall benefits of debt have all been realized.

Answer: E
Difficulty: 1 Easy
Section: 17.4 Integration of Tax Effects and Financial Distress Costs
Topic: Capital structure and firm valuation
Bloom's: Understand
AACSB: Reflective Thinking
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20) The optimal capital structure of a firm ________ the marketable claims and ________ the
nonmarketable claims against the cash flows of the firm.
A) minimizes; minimizes
B) minimizes; maximizes
C) maximizes; minimizes
D) maximizes; maximizes
E) equates; (leave blank)

Answer: C
Difficulty: 1 Easy
Section: 17.4 Integration of Tax Effects and Financial Distress Costs
Topic: Capital structure and firm valuation
Bloom's: Understand
AACSB: Reflective Thinking
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21) The MM theory with taxes implies that firms should issue maximum debt. In practice, this
does not occur because:
A) debt is more risky than equity.
B) bankruptcy is a disadvantage to debt.
C) the weighted average cost of capital is inversely related to the debt-equity ratio.
D) the weighted average cost of capital is directly related to the debt-equity ratio.
E) U.S. regulations require the debt-equity ratio of publicly-traded firms to be in the range of .3
to .7.

Answer: B
Difficulty: 1 Easy
Section: 17.4 Integration of Tax Effects and Financial Distress Costs
Topic: Capital structure and firm valuation
Bloom's: Understand
AACSB: Reflective Thinking
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22) Assuming the interest on the debt is fully tax deductible, when firms issue more debt, the
present value of the tax shield on debt ________ while the present value of the financial distress
costs ________.
A) decreases; decreases
B) increases; increases
C) decreases; remains constant
D) decreases; increases
E) increases; remains constant

Answer: B
Difficulty: 1 Easy
Section: 17.4 Integration of Tax Effects and Financial Distress Costs
Topic: Capital structure and firm valuation
Bloom's: Understand
AACSB: Reflective Thinking
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23) 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:
A) currently is all-equity financed and adding debt will cause a decrease in firm value.
B) wants to issue too few bonds to obtain the most benefit from debt.
C) will suffer from a decrease in its WACC if the bonds are issued.
D) is at, or has exceeded, its optimal debt-equity ratio.
E) will realize greater tax benefits by issuing equity securities.

Answer: D
Difficulty: 1 Easy
Section: 17.4 Integration of Tax Effects and Financial Distress Costs
Topic: Capital structure and firm valuation
Bloom's: Understand
AACSB: Reflective Thinking
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24) Which one of the following statements is true?

A) A firm with low anticipated profits will likely take on a high level of debt.
B) A successful firm will probably be all-equity financed.
C) Rational firms raise debt levels when profits are expected to decline.
D) Rational investors are likely to infer a firm is more valuable when its debt level declines.
E) Investors will generally view an increase in debt as a positive sign for the firm's future value.

Answer: E
Difficulty: 1 Easy
Section: 17.5 Signaling
Topic: Capital structure and firm valuation
Bloom's: Understand
AACSB: Reflective Thinking
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25) A decrease in a firm's level of debt tends to imply:

A) an increase in the firm's market value.
B) an increase in future dividend payouts.
C) a decrease in the firm's stock price.
D) a decrease in the firm's position within its industry.
E) a decline in managerial efficiency.

Answer: C
Difficulty: 1 Easy
Section: 17.5 Signaling
Topic: Capital structure and firm valuation
Bloom's: Understand
AACSB: Reflective Thinking
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26) Assume that for the next two weeks, the bondholders of Western Markets have the option of
exchanging their bonds for common shares of the firm's stock. As a result of these exchanges,
you should expect the firm's debt-equity ratio to:
A) decline and the stock's price to also decline.
B) decline and the stock's price to remain constant.
C) decline and the stock's price to increase.
D) increase and the stock's price to increase.
E) increase and the stock's price to remain constant.

Answer: A
Difficulty: 1 Easy
Section: 17.5 Signaling
Topic: Capital structure and firm valuation
Bloom's: Understand
AACSB: Reflective Thinking
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27) The free cash flow hypothesis states that:

A) firms with greater free cash flow will pay higher dividends thereby reducing the risk of
financial distress.
B) firms with greater free cash flow should issue new equity to help minimize the wasting of
resources by managers.
C) issuing debt requires payments to creditors thereby reducing the ability of managers to waste
resources.
D) firms should reduce their debt levels as their level of free cash flow rises.
E) firms with higher levels of free cash flow should reward their managers with bonuses.

Answer: C
Difficulty: 1 Easy
Section: 17.6 Shirking, Perquisites, and Bad Investments: A Note on Agency Cost of Equity
Topic: Agency costs and problems
Bloom's: Understand
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28) Issuing debt instead of new equity in a closely held firm is most apt to cause:
A) the owner-manager to work less hard and shirk duties.
B) the owner-manager to consume more perquisites because the cost is passed to the debtholders.
C) both more shirking and perquisite consumption since the government provides a tax shield on
debt.
D) agency costs to fall as owner-managers do not need to worry about other shareholders.
E) the owner-manager to reduce shirking and perquisite consumption.

Answer: E
Difficulty: 1 Easy
Section: 17.6 Shirking, Perquisites, and Bad Investments: A Note on Agency Cost of Equity
Topic: Agency costs and problems
Bloom's: Understand
AACSB: Reflective Thinking
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29) The pecking order states that firms should:

A) use internal financing first.
B) always issue debt so the market won't know when managers believe the stock is overvalued.
C) issue new equity first.
D) issue debt first.
E) always issue equity to avoid financial distress costs.

Answer: A
Difficulty: 1 Easy
Section: 17.7 The Pecking-Order Theory
Topic: Pecking-order theory
Bloom's: Understand
AACSB: Reflective Thinking
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30) According to the pecking-order theory, a firm's leverage ratio is determined by:
A) the value of the tax benefit of debt.
B) equating the tax benefit of debt to the financial distress costs of debt.
C) the firm's financing needs.
D) the market rate of interest.
E) the profitability of the firm.

Answer: C
Difficulty: 1 Easy
Section: 17.7 The Pecking-Order Theory
Topic: Pecking-order theory
Bloom's: Understand
AACSB: Reflective Thinking
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31) Which one of the following is not implied by the pecking order theory?
A) Profitable firms tend to use less debt than unprofitable firms.
B) Companies like having financial slack.
C) Companies prefer to borrow up to the point where the financial distress costs offset the tax
benefit of debt.
D) There is no target debt-equity ratio for a firm.
E) Firms tend to accumulate cash in anticipation of future projects.

Answer: C
Difficulty: 1 Easy
Section: 17.7 The Pecking-Order Theory
Topic: Pecking-order theory
Bloom's: Understand
AACSB: Reflective Thinking
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32) The introduction of personal taxes may reveal a disadvantage to the use of corporate debt if
the personal tax rate on:
A) the distribution of income to stockholders is less than the personal tax rate on interest income.
B) the distribution of income to stockholders is greater than the personal tax rate on interest
income.
C) the distribution of income to stockholders is equal to the personal tax rate on interest income.
D) interest income is zero.
E) dividends and interest are equal.

Answer: A
Difficulty: 1 Easy
Section: 17.8 Personal Taxes
Topic: Taxes and related issues
Bloom's: Understand
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33) Ignore financial distress costs. When [(1 TC ) × (1 TS ) = (1 TB)], then
firms:
A) should be all-equity financed.
B) need to maintain a debt-equity ratio of .5.
C) tend to be indifferent between issuing debt or issuing equity.
D) discover that both dividends and interest payments are non-deductible business expenses.
E) can reduce their taxes by increasing their dividend payouts.

Answer: C
Difficulty: 1 Easy
Section: 17.8 Personal Taxes
Topic: Taxes
Bloom's: Understand
AACSB: Reflective Thinking
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34) Of these five U.S. industries, which one tends to have the highest level of debt as a
percentage of the market value of debt plus equity?
A) Construction supplies
B) Semiconductor
C) Hotel/gaming
D) Online retail
E) Healthcare products

Answer: C
Difficulty: 1 Easy
Section: 17.9 How Firms Establish Capital Structure
Topic: Capital structure observations
Bloom's: Understand
AACSB: Reflective Thinking
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35) Studies have found that firms with large investments in tangible assets tend to have:
A) higher financial distress costs than firms with comparable investments in intangible assets.
B) zero debt.
C) higher target debt-equity ratios than firms that primarily invest in intangible assets.
D) the highest financial distress costs of any firm per dollar of debt.
E) the same capital structure as firms that specialize in intangible asset investments.

Answer: C
Difficulty: 1 Easy
Section: 17.9 How Firms Establish Capital Structure
Topic: Capital structure observations
Bloom's: Understand
AACSB: Reflective Thinking
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36) Which three factors are generally considered to be the most important when determining a
target debt-equity ratio?
A) Taxes, asset types, and inflation rate
B) Asset types, current operating income, and inflation rates
C) Taxes, current operating income, and future operating income
D) Taxes, asset types, and uncertainty of operating income
E) Interest rates, inflation rates, and tax rates

Answer: D
Difficulty: 1 Easy
Section: 17.9 How Firms Establish Capital Structure
Topic: Capital structure observations
Bloom's: Understand
AACSB: Reflective Thinking
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37) Which one of the following is not empirically correct?

A) Some firms use no debt.
B) The capital structure of a firm can vary significantly over time.
C) Capital structures are fairly constant across industries.
D) Debt levels across industries vary widely.
E) Debt ratios in most countries are considerably less than 100 percent.

Answer: C
Difficulty: 1 Easy
Section: 17.9 How Firms Establish Capital Structure
Topic: Capital structure observations
Bloom's: Understand
AACSB: Reflective Thinking
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38) The optimal capital structure:

A) is identical for all firms in the same industry.
B) will remain constant over time unless the firm makes an acquisition.
C) of a particular firm can change if tax rates change.
D) places more emphasis on the operations of a firm rather than the financing of a firm.
E) is unaffected by changes in the financial markets.

Answer: C
Difficulty: 1 Easy
Section: 17.9 How Firms Establish Capital Structure
Topic: Capital structure
Bloom's: Understand
AACSB: Reflective Thinking
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39) Corporations in the U.S., as compared to other countries, tend to:
A) have a median leverage ratio that's equal to the average international median leverage ratio.
B) underutilize debt.
C) rely less on equity financing than they should.
D) have extremely high debt-equity ratios.
E) have relatively high leverage ratios due to the tax benefits gained.

Answer: B
Difficulty: 1 Easy
Section: 17.9 How Firms Establish Capital Structure
Topic: Capital structure observations
Bloom's: Understand
AACSB: Reflective Thinking
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40) In general, U.S. firms:

A) tend to overweigh debt in relation to equity.
B) that are highly profitable tend to have lower target debt-equity ratios than unprofitable firms.
C) tend to maintain similar capital structures across all industries.
D) tend to maximize the use of every dollar of the tax benefits of debt.
E) that are family-owned tend to have very low levels of debt.

Answer: E
Difficulty: 1 Easy
Section: 17.9 How Firms Establish Capital Structure
Topic: Capital structure observations
Bloom's: Understand
AACSB: Reflective Thinking
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41) Many firms base their actual capital structure decisions on which two factors?
A) Inflation and tax rates
B) Interest and tax rates
C) Need for financial slack and current interest rates
D) Need for financial slack and industry averages
E) Types of assets held and current interest rates

Answer: D
Difficulty: 1 Easy
Section: 17.9 How Firms Establish Capital Structure
Topic: Capital structure observations
Bloom's: Understand
AACSB: Reflective Thinking
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42) The Wiz Co. owes $60 to its bondholders for the payment of principal and interest. The
company expects to have a cash flow of $136 if the economy continues as it is but that cash flow
will decrease to $54 if the economy enters a recession. Should the company ever face the real
possibility of bankruptcy, it will incur legal and other fees of $30. What amount will the
bondholders be paid in the case of a recession?
A) $30
B) $60
C) $54
D) $24
E) $0

Answer: D
Explanation: Bondholder payment = $54 $30
Bondholder payment = $24
Difficulty: 2 Medium
Section: 17.1 Costs of Financial Distress
Topic: Financial distress
Bloom's: Apply
AACSB: Knowledge Application
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43) TL Company has outstanding debt of $50 that is due in one year. However, given the
financial distress costs, the debtholders will only receive $40 if the firm does well and $15 if it
does poorly. The probability the firm will do well is 60 percent with the 40 percent probability
assigned to poor conditions. What is the current value of the debt if the discount rate is 8
percent?
A) $27.78
B) $27.50
C) $30.00
D) $26.67
E) $28.40

Answer: A
Explanation: Debt value = [.6($40) + .4($15)]/1.08
Debt value = $27.78
Difficulty: 2 Medium
Section: 17.1 Costs of Financial Distress
Topic: Financial distress
Bloom's: Apply
AACSB: Knowledge Application
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44) Assume CRT debtholders are promised payments in one year of $35 if the firm does well
and $20 if the firm does poorly. There is a 50/50 chance of the firm doing well or poorly. If
debtholders are willing to pay $25.50 today to purchase this debt, what is the promised return to
those debtholders?
A) 7.3 percent
B) 6.8 percent
C) 1.7 percent
D) 7.8 percent
E) 8.2 percent

Answer: D
Explanation: Expected return = [.5($35) + .5($20) $25.50)]/$25.50
Expected return = .078, or 7.8%
Difficulty: 2 Medium
Section: 17.1 Costs of Financial Distress
Topic: Financial distress
Bloom's: Analyze
AACSB: Analytical Thinking
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45) Adept Inc. is currently valued at $145,700 in a boom and $75,200 in a recession. The chance
of either economic state occurring is 50 percent. The firm owes $85,000 to its debt holders. What
is the value of the firm to the shareholders in a recession?
A) $22.50
B) $55.00
C) $27.50
D) $10.00
E) $0

Answer: E
Explanation: Shareholder valueRecession = MAX[($75,200 85,000),0]
Shareholder valueRecession = $0
Difficulty: 2 Medium
Section: 17.2 Description of Financial Distress Costs
Topic: Agency costs and problems
Bloom's: Analyze
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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46) AZC Company is currently valued at $300 in a boom and $160 otherwise. The chance of a
boom is 35 percent. What is the value of the firm to the shareholders if the firm owes $200 to its
debtholders?
A) $0
B) $35
C) $27.50
D) $209
E) $9

Answer: B
Explanation: Shareholder value = .35MAX[($300 200),0] + (1 .35)MAX[($160 200),0]
Shareholder value = $35
Difficulty: 2 Medium
Section: 17.2 Description of Financial Distress Costs
Topic: Agency costs and problems
Bloom's: Analyze
AACSB: Analytical Thinking
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47) LDL Transport is subject to claims from four parties as follows: tax claims = $6,740;
bondholder claims = $28,520; bankruptcy claims = $4,300; and shareholder claims = $33,190.
What is the total value of the marketed claims?
A) $61,710
B) $33,190
C) $72,750
D) $39,560
E) $66,010

Answer: A
Explanation: Marketed claims = $28,520 + 33,190
Marketed claims = $61,710
Difficulty: 2 Medium
Section: 17.4 Integration of Tax Effects and Financial Distress Costs
Topic: Marketed and nonmarketed claims
Bloom's: Apply
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48) Mary owns 100 percent of a gift shop with an equity value of $150,000. If she keeps the shop
open 5 days a week, EBIT is $75,000. If the shop remains open 6 days a week, EBIT increases to
$92,000 annually. Mary needs an additional $50,000 which she can raise today by either selling
stock or issuing debt at an interest rate of 7 percent. The principal amount would be repaid in
equal annual payments at the end of the next five years. Ignore taxes. What will be the cash flow
for the next year to Mary if she issues stock to another individual, remains open 6 days a week,
and distributes all the residual cash flow to the shareholders?
A) $58,750
B) $61,333
C) $92,000
D) $42,000
E) $69,000

Answer: E
Explanation: Cash flow to Mary = $92,000[($150,000)/($150,000 + 50,000)]
Cash flow to Mary = $69,000
Difficulty: 2 Medium
Section: 17.6 Shirking, Perquisites, and Bad Investments: A Note on Agency Cost of Equity
Topic: Agency costs and problems
Bloom's: Analyze
AACSB: Analytical Thinking
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49) Mary owns 100 percent of a gift shop with an equity value of $150,000. If she keeps the shop
open 5 days a week, EBIT is $75,000. If the shop remains open 6 days a week, EBIT increases to
$92,000 annually. Mary needs an additional $50,000 which she can raise today by either selling
stock or issuing debt at an interest rate of 7 percent. The principal amount would be repaid in
equal annual payments at the end of the next five years. Ignore taxes. What will be the cash flow
for the year to Mary if she issues debt, remains open 5 days a week, and distributes all the
residual cash flow to the shareholders?
A) $46,125
B) $61,500
C) $65,000
D) $71,500
E) $67,880

Answer: B
Explanation: Cash flow to Mary = $75,000 .07($50,000) $10,000
Cash flow to Mary = $61,500
Difficulty: 2 Medium
Section: 17.6 Shirking, Perquisites, and Bad Investments: A Note on Agency Cost of Equity
Topic: Agency costs and problems
Bloom's: Analyze
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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50) Mary owns 100 percent of a gift shop with an equity value of $150,000. If she keeps the shop
open 5 days a week, EBIT is $75,000. If the shop remains open 6 days a week, EBIT increases to
$92,000 annually. Mary needs an additional $50,000 which she can raise today by either selling
stock or issuing debt at an interest rate of 7 percent. The principal amount would be repaid in
equal annual payments at the end of the next five years. Ignore taxes. What will be the cash flow
for the next year to Mary if she issues stock to another individual, remains open 5 days a week,
and distributes all the residual cash flow to the shareholders?
A) $92,000
B) $61,333
C) $69,000
D) $42,000
E) $56,250

Answer: E
Explanation: Cash flow to Mary = $75,000[($150,000)/($150,000 + 50,000)]
Cash flow to Mary = $56,250
Difficulty: 2 Medium
Section: 17.6 Shirking, Perquisites, and Bad Investments: A Note on Agency Cost of Equity
Topic: Agency costs and problems
Bloom's: Analyze
AACSB: Analytical Thinking
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51) Mary owns 100 percent of a gift shop with an equity value of $150,000. If she keeps the shop
open 5 days a week, EBIT is $75,000. If the shop remains open 6 days a week, EBIT increases to
$92,000 annually. Mary needs an additional $50,000 which she can raise today by either selling
stock or issuing debt at an interest rate of 7 percent. The principal amount would be repaid at the
end of the fifth year. Ignore taxes. What will be the cash flow for this year to Mary if she issues
debt, remains open 6 days a week, and distributes all the residual cash flow to the shareholders?
A) $46,125
B) $88,500
C) $65,000
D) $71,500
E) $81,500

Answer: B
Explanation: Cash flow to Mary = $92,000 .07($50,000)
Cash flow to Mary = $88,500
Difficulty: 2 Medium
Section: 17.6 Shirking, Perquisites, and Bad Investments: A Note on Agency Cost of Equity
Topic: Agency costs and problems
Bloom's: Analyze
AACSB: Analytical Thinking
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52) Allison's requires $180,000 to fund a new project next year. The firm expects to earn excess
cash of $68,000 this year after all expenses, taxes, and dividends are paid. The firm can borrow
up to $150,000 at 6.5 percent interest for up to ten years or, it can issue up to 25,000 new shares
of stock that will have an estimated value of $35 a share at the end of this year. According to the
pecking-order theory, how much will the firm raise in new equity capital to fund this project?
A) $0
B) $30,000
C) $112,000
D) $90,000
E) $180,000

Answer: A
Explanation: New equity capital = MAX[($180,000 68,000 150,000),0]
New equity capital = $0
Difficulty: 2 Medium
Section: 17.7 The Pecking-Order Theory
Topic: Pecking-order theory
Bloom's: Analyze
AACSB: Analytical Thinking
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53) Assume the corporate tax rate is 22 percent, the personal tax rate on interest income is 15
percent, and the personal tax rate on dividends is 10 percent. Also assume the firm earns $5 per
share in taxable income and pays out 40 percent of its earnings. How much will a shareholder
receive per share in aftertax income?
A) $1.470
B) $1.782
C) $1.096
D) $1.232
E) $1.404

Answer: E
Explanation: Aftertax income = $5(.40)(1 .22)(1 .10)
Aftertax income = $1.404
Difficulty: 2 Medium
Section: 17.8 Personal Taxes
Topic: Tax effects on dividends and payouts
Bloom's: Analyze
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54) Assume BJ Companies is indifferent between issuing equity and issuing debt. Assume the
corporate tax rate is 21 percent and dividends are taxed at the personal level at 20 percent. What
is the personal tax on interest income?
A) 20 percent
B) 42 percent
C) 40 percent
D) 14 percent
E) 37 percent

Answer: E
Explanation: (1 TB ) = (1 TC )(1 TS)
(1 TB ) = (1 .21)(1 .20)
TB = .37, or 37%
Difficulty: 2 Medium
Section: 17.8 Personal Taxes
Topic: Tax effects on dividends and payouts
Bloom's: Analyze
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55) The All-Mine Corporation is deciding whether to invest in a new one-year project. The
project would have to be financed by equity, the cost is $2,000, and the return will be a
guaranteed $2,500 in one year. The discount rate for both bonds and stock is 15 percent and the
tax rate is zero. The predicted cash flows excluding this new project are $4,500 in a good
economy, $3,000 in an average economy, and $1,000 in a poor economy. Each economic
outcome is equally likely to occur and the promised debt repayment is $3,000. Should the
company take the project? What is the value of the firm and its debt and equity components
before and after the project addition?

Answer: Values prior to the new project:

Averag
Good Poor
e
Firm's cash flow $ 4,500 $ 3,000 $ 1,000
Debt claim 3,000 3,000 1,000
Equity claim 1,500 0 0

Value of debt = [($3,000 + 3,000 + 1,000)/3]/1.15

Value of debt = $2,028.99
Value of equity = [($1,500 + 0 + 0)/3]/1.15
Value of equity = $434.78

Values with the new project:

Averag
Good Poor
e
Firm's cash flow $ 7,000 $ 5,500 $ 3,500
Debt claim 3,000 3,000 3,000
Equity claim 4,000 2,500 500

Value of debt = [($3,000 + 3,000 + 3,000)/3]/1.15

Value of debt = $2,608.70
Value of equity = [($4,000 + 2,500 + 500)/3]/1.15
Value of equity = $2,028.99

Changes in value:
Withou
With t
project project Difference
Debt $ 2,608.70 $ 2,028.99 $ 579.71
Equity 2,028.99 434.78 1,594.21

NPV to shareholders = $1,594.21 2,000

NPV to shareholders = $405.79
If the firm keeps shareholder value as it primary goal, which it should, then the firm should reject
the project as it has a negative NPV for the shareholders.
Difficulty: 2 Medium
Section: 17.2 Description of Financial Distress Costs

29
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Topic: Agency costs and problems
Bloom's: Analyze
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

56) Wigdor Manufacturing is currently all-equity financed, has an EBIT of $2 million and has a
corporate tax rate of 21 percent. Louis, the company's founder, is the lone shareholder. All
earnings are paid out as dividends to Louis. If the firm were to convert $4 million of equity into
debt at a cost of 10 percent, what would be the total cash flow from the firm to Louis if he holds
all the debt? Compare this to Louis' total cash flow if the firm remains unlevered.

Answer:
Unlevere
Levered
d
EBIT $ 2,000,000 $ 2,000,000

Interest 0 400,000

EBT $ 2,000,000 $ 1,600,000

Taxes (21%) 420,000 336,000

Aftertax earnings = Dividends $ 1,580,000 $ 1,264,000

Interest income to Louis 0 400,000
Total cash flow to Louis $ 1,580,000 $ 1,664,000
Difficulty: 2 Medium
Section: 17.4 Integration of Tax Effects and Financial Distress Costs
Topic: Tax effects on dividends and payouts
Bloom's: Analyze
AACSB: Analytical Thinking
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57) What is the pecking order theory and what are the implications that arise from this theory?

Answer: The pecking order theory states that firms should first use internal financing, which
includes retained earnings. If the firm then requires external financing, it should issue the safer
securities, such as debt, first.

The implications of this theory are:

There is no target amount of leverage.

Profitable firms use less debt.
Companies like financial slack.
Difficulty: 2 Medium
Section: 17.7 The Pecking-Order Theory
Topic: Pecking-order theory

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58) Wigdor Manufacturing is currently all-equity financed, has an EBIT of $2 million and has a
corporate tax rate of 21 percent. Louis, the company's founder, is the lone shareholder. All
earnings are paid out as dividends to Louis. If the firm were to convert $4 million of equity into
debt, the cost would be 10 percent and Louis would hold all the debt. Assume Louis pays
personal taxes on interest income at a rate of 37 percent but pays taxes on dividends at a rate of
20 percent. Calculate the total cash flow to Louis after he pays personal taxes if the firm is
unlevered and if it is levered.

Answer:
Unlevere
Firm: Levered
d
EBIT $ 2,000,000 $ 2,000,000

Interest 0 400,000

EBT $ 2,000,000 $ 1,600,000

Taxes (21%) 420,000 336,000

Aftertax earnings = Dividends $ 1,580,000 $ 1,264,000

Louis:
Dividend income $ 1,58,000 1,264,000

Tax on dividends (20%) 316,000 252,800

Interest income 0 400,000

Tax on interest (37%) 0 148,000

Total aftertax cash flow to Louis $ 1,264,000 $ 1,263,200

Difficulty: 2 Medium
Section: 17.8 Personal Taxes
Topic: Tax effects on dividends and payouts
Bloom's: Analyze
AACSB: Analytical Thinking
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59) Is there an easily quantifiable debt-equity ratio that will maximize the value of a firm? Why
or why not?

Answer: In a world with taxes, economic uncertainty, and financial distress costs, there are both
benefits and costs to higher debt loads but there is no way to target exactly what the ideal capital
structure should be.
Difficulty: 2 Medium
Section: 17.9 How Firms Establish Capital Structure
Topic: Capital structure and firm valuation
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60) Describe some of the sources of business risk and financial risk. Do financial decision
makers have the ability to "trade off" one type of risk for another type of risk?

Answer: Some of the observed variations in capital structures across industries reflect the
differences in the nature of the industries themselves, i.e., business risk. Similarly, intuition
would suggest that firms with large capital requirements and stable cash flows (e.g., electric
utilities) are more likely to be willing to raise funds via large amounts of borrowing (financial
risk). Alternatively, firms with lower tangible asset needs and highly uncertain cash flows (e.g.,
small software companies) are more likely to employ equity. Thus, firms with lower business
risk may tend to accept higher levels of financial risk and vice versa. Thus, firms can and do
trade off financial and business risks.
Difficulty: 2 Medium
Section: 17.9 How Firms Establish Capital Structure
Topic: Capital structure observations
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