Chapter 16

Question 1

What is financial leverage?

Answer 1

Increase the firm’s debt financing while keeping the total amount of capital unchanged.

Question 2

How does leverage affect equity and debt?

Answer 2

Leverage decreases equity and increases debt.

Question 3

What effect does leverage have on a firm’s cost of equity?

Answer 3

Leverage affects the firm’s cost of equity, thus affecting the shareholder’s welfare.

Question 4

How does leverage amplify the variation in EPS and ROE?

Answer 4

Leverage amplifies the variation in both EPS and ROE.

Question 5

What is the current capital structure when there is no debt?

Answer 5

Assets are fully equity financed.

Question 6

What is the impact of issuing debt and buying back shares on EPS and ROE?

Answer 6

EPS and ROE vary based on the amount of debt and the resulting fixed interest expenses.

Question 7

What is the static theory in capital structure?

Answer 7

It posits that the value of the firm is determined by its cash flows and risk of the assets.

Question 8

What are the three cases in the static theory?

Answer 8

• Case I: No corporate or personal taxes, no bankruptcy costs * Case II: With corporate taxes, no personal taxes, no bankruptcy costs * Case III: With corporate taxes, no personal taxes, and bankruptcy costs.

Question 9

What does Modigliani and Miller Proposition I state?

Answer 9

The value of the firm is NOT affected by changes in the capital structure.

Question 10

What is the implication of Proposition II in Modigliani and Miller theory?

Answer 10

WACC = (E/V)RE + (D/V)RD.

Question 11

What happens to the value of a levered firm according to Case II?

Answer 11

The value of a levered firm increases by the present value of the annual interest tax shield.

Question 12

True or False: The WACC decreases as the debt-to-equity ratio increases in Case II.

Answer 12

True.

Question 13

What are direct bankruptcy costs?

Answer 13

Legal and administrative costs incurred during bankruptcy proceedings.

Question 14

What are indirect bankruptcy costs?

Answer 14

Costs associated with lost sales, interrupted operations, and the loss of valuable employees.

Question 15

Define technical insolvency.

Answer 15

A firm is unable to meet debt obligations, often facing a liquidity crisis.

Question 16

Define accounting insolvency.

Answer 16

A situation where the value of a company’s liabilities exceeds its assets.

Question 17

What is bankruptcy?

Answer 17

A discharge of the debtor’s obligations through court order.

Question 18

What is the purpose of bankruptcy?

Answer 18

To provide the debtor with a fresh start and to ensure equitable distribution of the debtor’s assets among creditors.

Question 19

Fill in the blank: The value of an unlevered firm can be expressed as VU = EBIT / _______.

Answer 19

RE

Question 20

Fill in the blank: In Case II, the value of equity is calculated as E = VL - _______.

Answer 20

D

Question 21

What is the relationship between systematic risk and financial leverage?

Answer 21

Financial leverage increases the systematic risk of the stock.

Question 22

What happens to the firm’s value when bankruptcy costs are added?

Answer 22

The value of the firm can decrease as the D/E ratio increases.

Question 23

What is the expected impact of increased debt on a firm’s WACC?

Answer 23

WACC will start to increase as more debt is added due to bankruptcy costs.

Question 24

What is bankruptcy?

Answer 24

A discharge of the debtor’s obligations through court order.

The purpose of bankruptcy is to provide the debtor with a fresh start and to have an equitable distribution of the debtor’s assets among the creditors.

Question 25

What is the Bankruptcy Reform Act of 1978?

Answer 25

A major federal law concerning bankruptcy in the USA. ## Footnote It includes different chapters that address various types of bankruptcy.

Question 26

What does Chapter 7 of bankruptcy deal with?

Answer 26

Corporate bankruptcy. ## Footnote It involves liquidation of the company's assets.

Question 27

What does Chapter 9 of bankruptcy involve?

Answer 27

Procedures for municipal bankruptcy. ## Footnote This chapter allows municipalities to reorganize their debts.

Question 28

What is Chapter 13 bankruptcy?

Answer 28

Pertains to individual bankruptcy. ## Footnote It allows individuals to create a plan to repay all or part of their debts.

Question 29

What is Chapter 11 bankruptcy?

Answer 29

Deals with reorganization of a business. ## Footnote This can be voluntary or involuntary.

Question 30

What is liquidation in the context of bankruptcy?

Answer 30

Firm is terminated as a going concern, and a trustee takes over assets, sells them, and distributes the proceeds. ## Footnote Covered under the Bankruptcy and Insolvency Act (1992).

Question 31

What is reorganization in bankruptcy?

Answer 31

Keeps the firm as a going concern and involves issuing new securities to replace old securities. ## Footnote It depends on whether the company is worth more dead or alive.

Question 32

What is the optimal capital structure according to the static theory?

Answer 32

A firm borrows up to the point where the tax benefit from an extra dollar in debt equals the cost from increased probability of financial distress. ## Footnote This point minimizes the firm’s WACC.

Question 33

What is the extended pie theory?

Answer 33

Value of the firm = marketed claims + nonmarketed claims. ## Footnote Marketed claims are those of stockholders and bondholders, while nonmarketed claims are from the government and other stakeholders.

Question 34

What are marketed claims?

Answer 34

Claims of stockholders and bondholders. ## Footnote These are financial claims that can be traded in the market.

Question 35

What are nonmarketed claims?

Answer 35

Claims of the government and other potential stakeholders. ## Footnote These claims are not traded and may include taxes or regulations.

Question 36

According to the pecking order theory, what is the preferred order of financing?

Answer 36

* Internal finance * Debt finance * Equity finance ## Footnote This theory predicts that firms prefer to use internal funds before seeking external financing.

Question 37

Does the pecking order theory predict a target capital structure?

Answer 37

No target capital structure. ## Footnote Unlike the static theory, it does not suggest firms aim for an optimal capital structure.

Question 38

What is a characteristic of profitable firms regarding debt according to the pecking order theory?

Answer 38

Profitable firms use less debt. ## Footnote This is to maintain financial slack.

Question 39

How does capital structure differ by industry?

Answer 39

Capital structure does differ by industry. ## Footnote There seems to be a connection between different industry's operating characteristics and capital structure.

Question 40

What do firms and lenders consider regarding capital structure?

Answer 40

They look at the industry’s debt/equity ratio as a guide. ## Footnote This can influence lending decisions and capital structure planning.