Q&A Hero

Q: Under the pecking order theory, debt is factually the cheapest source of funds due to the interest tax shield. A) True B) False

Q: The trade-off theory of capital structure states that leverage is increased until the marginal cost of debt is equal to the marginal benefit. A) True B) False

Q: Without debt in the capital structure, there are no asset substitution or underinvestment problems. A) True B) False

Q: When a firm is in financial distress, stockholders would like to overinvest in positive NPV projects. A) True B) False

Q: Borrowing money and paying out a special dividend to shareholders is an example of the asset substitution problem. A) True B) False

Q: Dividends reduce the value of lender claims, and this is why bondholders often limit a firm's ability to distribute cash to equity holders. A) True B) False

Q: More debt in a firm's capital structure provides managers with an incentive to maximize cash flows, but also makes them want to take on negative NPV projects. A) True B) False

Q: Indirect bankruptcy costs will often increase when a firm is in financial stress and it may even push the company into bankruptcy. A) True B) False

Q: Unlike direct bankruptcy costs, indirect costs are not considered transaction costs. A) True B) False

Q: Indirect bankruptcy costs include changes in customer and supplier behavior that negatively affect the firm. A) True B) False

Q: Direct bankruptcy costs are considered small when compared to indirect costs. A) True B) False

Q: When a firm gets closer to financial distress causing expected bankruptcy costs to increase, lenders will often charge the firm a lower interest rate in order to reduce the chance of an actual bankruptcy occurring. A) True B) False

Q: Direct-bankruptcy costs are considered transactions costs and occur when a firm must navigate the bankruptcy process. A) True B) False

Q: Bankruptcy and agency costs both act as limits on the amount of debt in the capital structure. A) True B) False

Q: Issuing debt is less expensive than issuing stock. A) True B) False

Q: If a firm has debt and pays taxes, the present value of the tax shield is the amount of debt outstanding times the tax rate. A) True B) False

Q: With no debt, the WACC is the cost of equity plus the required rate of return on the firm's underlying assets. A) True B) False

Q: Under the M&M assumptions with taxes, the value of a firm with debt is the value of the firm without debt plus the present value of the interest tax shield. A) True B) False

Q: M&M Proposition 1 states that the capital structure of a firm does not affect the required rate of return on a firm's assets, while M&M Proposition 2 shows that the required rate of return on firm's equity does change with capital structure decisions. A) True B) False

Q: M&M Proposition 2 states that the required rate of return on a firm's common stock is directly related to the debt-to-equity ratio. A) True B) False

Q: A financial restructuring can change the value of a firm's real assets, such as plant and equipment. A) True B) False

Q: The enterprise value of a firm is the value of equity minus the value of debt. A) True B) False

Q: M&M Proposition 1 assumes that the mix of debt and equity that a firm chooses does not affect real investment policy. A) True B) False

Q: When calculating free cash flow, it is important to include interest and principal payments. A) True B) False

Q: Minimizing the cost of a firm's financing activities also maximizes the overall value of the firm. A) True B) False

Q: A higher fraction of debt indicates a lower degree of financial leverage. A) True B) False

Q: The pecking order theory of capital structure suggests that managers will choose to utilize retained earnings before issuing additional debt when financing new projects. Does that imply anything about the flotation costs of issuing new securities?

Q: Briefly explain how an increase in the amount of debt that a firm has outstanding may actually decrease the agency costs caused by the conflict between managers and stockholders.

Q: One of the conditions that the M&M Propositions required was for not to have taxes. Briefly discuss whether the introduction of taxes decreases or increases the value of the firm.

Q: LMNO Manufacturing needs a new laser and is comparing buying or leasing. Under either alternative, the company will only need the laser for 5 years. Assume LMNO's marginal tax rate is 30 percent.Purchase Alternative: It would cost $50,000 to purchase the laser and the amount could be financed with a five year balloon loan at 9%. The laser will be depreciated on straight line and have no salvage value. Maintenance on the laser is expected to be $1,200 per year.Lease alternative: The company that manufactures the laser offers a 5 year leasing option with annual lease payments of $12,500.With this option, the lessor will be responsible for maintenance of the laser and will take it back after 5 years. The lease will be classified as an operating lease.Which is the best option for LMNO Manufacturing?(Do not round the intermediate calculation. Round off final answer to the nearest dollar.)A) Purchase, the company will be $4,416 better offB) Lease, the company will be $4,416 better offC) Purchase, the company is $10,496 better offD) Lease, the company is $10,496 better off

Q: Which of the following arises when the lessee can have the incentive to use the asset more than the lessor would prefer? A) Track the total services obtained from the asset and charge the lessee based on usage. B) Bundle the lease contract with a service contract. C) Provide the lessee with the right to buy the asset when the lease expires. D) All of the above.

Q: Which of the following would arise if the lessee can have the incentive to use the asset more than the lessor would prefer? A) Operating lease conflict B) Capital lease conflict C) Intensity of use conflict D) Maintenance conflict

Q: Which of the following should a company consider when deciding to buy or lease an asset? A) Taxes. B) Information or transaction costs. C) If the choice would affect the real investment policy of the firm. D) All of the above.

Q: A firm wishes to undertake a project that costs $150 million. It currently has $10 million in cash on hand and believes that it can raise $75 million in debt and $100 million in equity if needed. According to the pecking order theory of the capital structure, what percent of the project will be financed by debt? A) 0% B) 26.67% C) 50% D) None of the above

Q: Which of the following supports the trade-off theory of capital structure? A) Firms use cash on hand first, since issuing equity and debt is expensive. B) A firm's capital structure is the result of past equity and debt issuance decisions. C) Firms have a target capital structure. D) Both A and B

Q: Suppose that, JMK, Inc. has debt with a face value of $100 million and assets worth $70 million. The firm's management has just identified a project that will require an initial outlay of $10 million and will return a NPV of $16 million, risk-free. The firm currently has no cash. What would be the net return to stockholders if they took on this project? A) −$10 million B) $0 million C) $26 million D) $70 million

Q: Suppose that UBM Corp. has invested $100 million in 8% risk-free bonds that mature in one-year. The firm also has $80 million in debt outstanding that will also mature in a year. UBM stockholders are considering selling the $100 million in debt and investing in a project that has a 60% chance of returning $200 million and a 40% chance of returning $2 million. Given the payoffs of the project, what does the percent chance of success need to be in order for the expected value of equity with the project to be equal to the expected value of equity without the project? A) 1/3 B) 1/4 C) 1/5 D) 1/6

Q: Suppose that UBM Corp. has invested $100 million in 8% risk-free bonds that mature in one-year. The firm also has $80 million in debt outstanding that will also mature in a year. UBM stockholders are considering selling the $100 million in debt and investing in a project that has a 60% chance of returning $200 million and a 40% chance of returning $2 million. What is the expected value of the equity if the stockholders sell the debt? A) $175 million B) $97.5 million C) $51 million D) $40 million

Q: Suppose that UBM Corp. has invested $100 million in 8% risk-free bonds that mature in one-year. The firm also has $80 million in debt outstanding that will also mature in a year. UBM stockholders are considering selling the $100 million in debt and investing in a project that has a 60% chance of returning $200 million and a 40% chance of returning $2 million. What is the expected value of the bonds to the lenders if the stockholders sell the debt? A) $100 million B) $88.8 million C) $48.8 million D) None of the above

Q: Suppose that UBM Corp. has invested $100 million in 8% risk-free bonds that mature in one-year. The firm also has $80 million in debt outstanding that will also mature in a year. UBM shareholders are considering selling the $100 million in debt and investing in a project that has a 60% chance of returning $200 million and a 40% chance of returning $2 million. What will the equity value of UBM be in one-year without stockholders taking on the project?A) $100 millionB) $80 millionC) $20 millionD) $8 million

Q: A firm plans to issue $1 million worth of debt at an YTM of 9%. The debt is trading at par. The firm's marginal corporate tax rate is 35%. What is the present value of the tax savings in perpetuity?A) $11,025B) $20,475C) $350,000D) $227,500

Q: A firm plans to issue $1 million worth of debt at an YTM of 9%. The debt is trading at par. The firm's marginal corporate tax rate is 25%, while its average tax rate is 15%. By how much will this debt issuance reduce the firm's annual tax liability?A) $13,500B) $22,500C) $32,500D) None of the above

Q: Packman Corporation has a reported EBIT of $500, which is expected to remain constant in perpetuity. The firm borrows $2,000, and its coupon rate is 8%. If the company's marginal tax rate is 30% and its average tax rate is 20%, what are its after-tax earnings?A) $238B) $272C) $259D) None of the above

Q: The underinvestment problem occurs in a financially distressed firm when A) the value of investing in a positive NPV project is likely to go to debt holders instead of equity holders. B) the value of investing in a positive NPV project is likely to go to equity holders instead of debt holders. C) management invests in negative NPV projects to reduce their own risk. D) issuing equity becomes difficult due to increased risk.

Q: The asset substitution problem occurs when A) managers substitute more risky assets for less risky ones to the detriment of bondholders. B) managers substitute less risky assets for more risky ones to the detriment of bondholders. C) managers substitute more risky assets for less risky ones to the detriment of equity holders. D) managers substitute less risky assets for riskier ones to the detriment of equity holders.

Q: The use of debt financing A) reduces agency costs between the stockholders and management by increasing the amount of risk the managers take. B) increases agency costs between the stockholders and management by limiting the amount of risk the managers take. C) increases agency costs since managers prefer to keep more retained earnings rather than paying dividend. D) Both B And C

Q: Which of these is NOT an example of indirect bankruptcy costs? A) A firm's customers become concerned about whether or not warranties will be honored. B) Employees begin to leave the firm. C) New accountants are brought in to help with the bankruptcy process. D) A bankruptcy judge orders new projects to be halted.

Q: Which of these statements about direct bankruptcy costs is NOT true? A) Direct bankruptcy costs include the hiring of additional accountants, lawyers, and consultants. B) Direct bankruptcy costs are less than indirect bankruptcy costs. C) Direct bankruptcy costs include payments to suppliers on delivery. D) Direct bankruptcy costs can be reduced by negotiating with lenders.

Q: The use of debt financing A) causes a manager to take on riskier projects in order to make interest payments. B) is more expensive than issuing equity due to the use of covenants. C) allows managers to make discretionary interest payments. D) limits the ability of managers to waste stockholders' money.

Q: Academic studies have estimated that the tax benefit of debt realized by firms is approximately A) 10% of firm value. B) a 10% reduction in WACC. C) a 10% reduction in the cost of debt. D) 10% of debt value.

Q: In order to calculate the present value of debt tax savings, the _____ is used as the discount rate. A) WACC B) risk-free rate C) required rate of return on debt D) None of the above

Q: The interest tax shieldA) does not affect the WACC.B) makes it less costly to distribute cash to the investors through interest payments than through dividends.C) is given as: D (1 - t).D) Both B and C

Q: Millennium Motors has current pretax annual cash flows of $1,000 and is in the 35% tax bracket. The appropriate discount rate for its cash flows is 12%. Suppose the firm issues a $1,500 bond and uses these proceeds to pay a one-time special dividend to stockholders What is Millennium's value after the debt issuance? Assume that the pretax annual cash flows are perpetual. A) $5,417 B) $5,942 C) $6,392 D) None of the above

Q: Millennium Motors has current pretax annual cash flows of $1,000 and is in the 35% tax bracket. The appropriate discount rate for its cash flows is 12%. Suppose the firm issues a $1,500 bond and uses these proceeds to pay a one-time special dividend to stockholders. Using the perpetuity model, calculate the value of the firm without debt in the capital structure. Assume that the pretax annual cash flows are perpetual. Round to the nearest dollar. A) $350 B) $650 C) $2,917 D) $5,417

Q: Suppose a firm has a cost of equity of 12%, a D/E ratioof 1/6, and the YTM on its bonds is 7.5%. The risk-free rate is currently 3%. What is the current required rate of return on its assets and equity if the D/E is changed to 1/3?(Round the answer to one decimal place of percentage.)A) 11.35% and 13.25%B) 11.35% and 8.25%C) 13.25% and 11.35%D) None of the above

Q: Suppose that Banana Computers has $1,000 in revenue this year, along with COGS of $400 and SG&A of $100. The required rate of return on its equity is 14%, and the risk-free rate is 5%. Assume that the COGS only include the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5% and an YTM of 7.9% to its capital structure. Suppose, revenues fall by $300, what is the percent change in net income with and without the debt? Assume that the total variable production costs remain the same.(Round the answer to one decimal places.)A) 64.5% and 60%B) 60.0% and 64.5%C) 59.2% and 40.8%D) 40.8% and 59.2%

Q: Suppose that Banana Computers has $1,000 in revenue this year, along with COGS of $400 and SG&A of $100. The required rate of return on its equity is 14%, and the risk-free rate is 5%. Assume that the COGS only include the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5% and an YTM of 7.9% to its capital structure. What is the net income of Banana without and with the debt? A) $500 and $484.2 B) $484.2 and $500 C) $500 and $465 D) $490 and $500

Q: Suppose that Banana Computers has $1,000 in revenue this year, along with COGS of $400 and SG&A of $100. The required rate of return on its equity is 14%, and the risk-free rate is 5%. Assume that the COGS only include the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5% and an YTM of 7.9% to its capital structure. What percent of the firm's costs are fixed, and what percent of costs are variable with the added debt? (Round the percentage answer to two decimal places.)A) 27.9% and 72.1%B) 72.1% and 27.9%C) 25.23 and 74.77%D) 74.77% and 25.23%

Q: Bellamee, Inc. has a required rate of return on its assets of 12% and a cost of debt of 6.25%. Its current debt-to-equity ratio is 1/5. What is its required return on equity if its debt-to-equity ratio changes to 2/5 and this increases the required rate of return on its debt to 7%? A) 14% B) 14.25% C) 14.50% D) 15%

Q: Bellamee, Inc. has a required rate of return on its assets of 12% and a cost of debt of 6.25%. Its current debt-to-equity ratio is 1/5. What is the required rate of return on its equity? A) 12.15% B) 13.15% C) 14.15% D) None of the above.

Q: What are PIPE transactions and how do they help firms raise capital?

Q: What are the advantages and disadvantages of going public?

Q: Why do traditional sources of funding not work for new or emerging businesses?

Q: Castle Co. needs to borrow $10 million for process improvement upgrades. Management decides to sell 20-year bonds. They determine that the 3-month Treasury bill rate is 2.75 percent, the firm's credit rating is A, and the yield on 20-year Treasury bonds is 1.80 percent higher than that for 3-month Treasury bills. Bonds with an A rating are selling for 50 basis points above the 20-year Treasury bond rate. What is the borrowing cost for this transaction? A) 4.55% B) 5.05% C) 7.75% D) 9.55%

Q: Marigold Corp. wants to borrow money from Howard Bank for a period of five years. The firm's credit standing calls for a premium of 1.5 percent over the prime rate. The current prime rate is 6.5 percent, the 30-year Treasury bond yield is 5.375 percent, the three-month Treasury bill yield is 3.525 percent, and the 5-year Treasury note yield is 4.25 percent. What is the appropriate loan rate for this customer? A) 8.725% B) 7.225% C) 6.500% D) None of the above

Q: Suppose two firms want to borrow money from a bank for a period of 10 years. Firm A has excellent credit and can borrow at the prime rate, whereas Firm B's credit standing is prime rate plus 2 percent. The current prime rate is 5.75 percent, the 30-year Treasury bond yield is 4.35 percent, the three-month Treasury bill yield is 3.54 percent, and the 10-year Treasury note yield is 4.24 percent. What are the appropriate loan rates for both the firms? A) 6.45% for Firm A, 7.75% for Firm B B) 6.45% for Firm A, 8.45% for Firm B C) 5.75% for Firm A, 8.45% for Firm B D) None of the above

Q: Jasper, Inc. is looking for a five-year term loan of $3 million. Its bank is willing to make the loan. The firm will have to pay a premium of 1.5 percent for default risk and another 0.75 percent for maturity risk. The current prime rate is 7.5 percent. What is the loan rate on this bank loan? A) 9% B) 8.25% C) 9.75% D) None of the above

Q: Which of the following statements is true of PIPE transactions? A) Under federal securities law, they can be resold to investors in the public markets immediately even if they are not registered. B) As part of the PIPE contract, the company often agrees to register the restricted securities with the SEC, usually within 90 days of the PIPE closing. C) As part of the PIPE contract, the company often agrees to register the restricted securities with the SEC after 90 days of the PIPE closing. D) PIPE transactions involving a healthy firm can also be executed without the use of an investment bank but result in a cost increase of 7 to 8 percent of the proceeds.

Q: Which of the following statements is NOT true of PIPE transactions? A) PIPE transactions are registered with the SEC. B) PIPE transaction gives issuers faster access to capital. C) In a PIPE transaction, investors purchase securities (equity or debt) directly from a publicly traded company in a private placement. D) The securities are virtually always sold to the investors at a discount to the price at which they would sell in the public markets.

Q: Private equity firms improve the performance of firms in which they invest by: A) making sure that the firms have the best possible management teams. B) closely monitoring each firm's performance and providing advice and counsel to the firm's management team. C) facilitating mergers and acquisitions that help improve the competitive positions of the companies in which they invest. D) All of the above

Q: Which of the following statements is NOT true? A) Private equity firms pool money from wealthy investors, pension funds, insurance companies, and other sources to make investments. B) Private equity firms invest in more mature companies. C) Agency problems tend to be more in firms owned by private equity investors than in public firms. D) Private equity investors focus on firms that have stable cash flows because they use a lot of debt to finance their acquisitions.

Q: Advantages of private placements include A) lower cost of funds. B) more willingness among private lenders to negotiate changes to a bond contract. C) the speed of private placement deals and flexibility in issue size. D) All of the above

Q: Which of the following statements is NOT true? A) Private placement occurs when a firm sells unregistered securities directly to investors such as insurance companies, commercial banks, or wealthy individuals. B) In private placements, there are no restrictions on the resale of the securities. C) About half of all corporate debt is sold through the private placement market. D) Investment banks and money center banks often assist firms with private placements.

Q: Which of the following statements is NOT true? A) For many smaller firms and firms of lower credit standing that have limited access, or no access, to the public markets, the cheapest source of external funding is often the private markets. B) Bootstrapping and venture capital financing are not part of the private market. C) The biggest drawback of private placements involves restrictions on the resale of the securities. D) Many private companies that are owned by entrepreneurs, families, or family foundations and are sizable companies of high credit quality prefer to sell their securities in the private markets.

Q: Why is the total cost of bringing a general cash offer to the market lower than issuing an IPO? A) General cash offer does not include a large underpricing B) Underwriting spreads are smaller in case of general cash offer C) There is less risk involved with a general cash offer than an IPO D) All of the above

Q: Star Corporation, an auto fuel cell maker, is planning a new plant and needs to raise $30 million to finance it. The company plans to raise the money through a general cash offering priced at $23.50 a share. Star's underwriters charge a 6 percent spread. How many shares does the company have to sell to achieve its goal? (Round your final answer to the nearest unit of share.) A) 1,358,081 shares B) 1,276,596 shares C) 1,200,000 shares D) None of the above

Q: Benefits from shelf registration include all EXCEPT A) greater flexibility in bringing securities to market. B) shelf registration allows firms to periodically sell small amounts of securities and raise capital as needed. C) a shelf registration statement can cover multiple securities, but there is a penalty if authorized securities are not issued. D) costs associated with selling the securities are reduced because only a single registration statement is required.

Q: Which of the following statements is NOT true of shelf registration? A) Shelf registration gives firms less flexibility in bringing securities to market. B) During a two-year window, the firm can take the securities "off the shelf" and sell them as needed. C) Shelf registration allows firms to periodically sell small amounts of securities. D) A shelf registration statement can cover multiple securities, and there is no penalty if authorized securities are not issued.

Q: Which of the following statements is NOT true? A) In a competitive sale, the firm specifies the type and amount of securities it wants to sell. B) In a negotiated sale, the issuer selects the underwriter at the beginning of the origination process. C) In a general cash offer, management must decide whether to sell the securities on a competitive or a negotiated basis. D) For equity securities, competitive sales generally provide the lowest-cost method of sale.

Q: A firm is making an initial public offering. The investment bankers agree to a firm underwriting commitment of 500,000 shares priced to the public at $50 a share. The underwriter's spread is 12%. In addition, the underwriter charges $600,000 in legal fees. On the first day of trading, the firm's stock closed at $61. What were the total costs of the issue? A) $3,000,000 B) $3,600,000 C) $8,500,000 D) $9,100,000