invic

Which of the following is least likely to be categorized as a cost of financial distress?

A) Legal fees paid to bankruptcy lawyers.

B) Having a potential merger partner pull out of a proposed deal.

C) Premiums paid for bonding insurance to guarantee management performance.

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Premiums paid for bonding insurance to guarantee management performance is an example of an agency cost. Agency costs are costs associated with the fact that all public companies are not managed by owners and the conflict of interest created by that fact. Costs of financial distress can be direct or indirect. Direct costs would include cash expenses associated with bankruptcy, such as legal and administrative fees, while indirect costs would include foregone business opportunities, inability to access capital markets, or loss of trust from customers, suppliers, or employees.

pacmandefense

Which of the following companies is most likely to have the greatest expected cost of financial distress?

A) An airline company with strong management.

B) A steel manufacturer with an average debt to equity ratio for the industry.

C) An information technology service provider with a weak corporate governance structure.

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The expected cost financial distress is related to the combination of the cost and probability of financial distress. Firms who have a ready secondary market for their assets such as airlines or steel manufacturers, have lower costs from financial distress due to the marketability of their assets. Firms with fewer tangible assets, such as information technology service providers, have less to liquidate and therefore have higher costs related to financial distress. The probability of financial distress is positively related to the amount of leverage on the balance sheet, and negatively related to the quality of a firm’s management and corporate governance structure

pacmandefense

Rupert Jones, a manager with Oswald Technologies, is confused about agency costs of equity and how they can be managed at his firm. To try to gain a better understanding about agency costs, Jones asks Karrie Converse, a well known consultant for an explanation. In their conversation, Converse makes the following statements:
Statement 1: Costs related to the conflict of interest between managers and owners of a business can be eliminated through a combination of bonding provisions and adequate monitoring through a quality corporate governance structure.
Statement 2: The less a company depends on debt in its capital structure, the lower the agency costs the company will tend to have.
Are Converse’s statements concerning the agency costs of equity correct?

A) Both are correct.

B) Both are incorrect.

C) Only one is correct.

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Both of Converse’s statements are incorrect. With regard to elimination of agency costs, residual losses may occur even with adequate monitoring and bonding provisions, because such provisions do not provide a perfect guarantee against losses. Also, if you read the statement carefully, it is contradictory because the costs associated with bonding insurance and monitoring are actual agency costs! The second statement is also incorrect because, according to agency theory, the use of debt forces managers to have discipline with regard to how they spend cash. This discipline causes greater amounts of leverage to correspond to a reduction in agency costs.

pacmandefense

Modigliani and Miller demonstrated that if corporate taxes are introduced into an otherwise perfect world, the optimal capital structure would be:

A) an equal amount of debt and equity.

B) all debt.

C) all equity.

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In this almost perfect world, the tax deductibility of interest payments encourages firms to use more debt in their capital structures. Since the more the firm borrows the greater the tax write-offs, the firm is encouraged to hold the maximum amount of debt possible. There could essentially be a single equity share, making up a very small portion of the financing, and the remainder, essentially 100%, would be financed with debt.

pacmandefense

Modigliani and Miller demonstrated that if corporate taxes and bankruptcy costs are introduced into an otherwise perfect world the weighted average cost of capital (WACC) will:

A) fall continuously as more debt is added to the capital structure.

B) fall, then bottom out, and finally start to rise.

C) rise, then plateau, and finally start to fall.

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The WACC first falls because bondholders take less risk and, consequently, have a lower required rate of return. In addition, interest expenses are tax deductible. However, as the amount of debt rises, financial risk rises, and the chance for bankruptcy increases. If there are positive bankruptcy costs, both bondholders and stockholders will require increasingly higher rates of return as financial risk increases causing the WACC to rise. This rise offsets the benefits of using the cheaper source of financing.

pacmandefense

Joseph Palmer is discussing the impact of the tax shield provided by debt with his supervisor, Ming Chou. During the course of their discussion, Palmer makes the following statements:

Statement 1:	The value of the tax shield provided by debt can be calculated by multiplying the pre-tax cost of debt by (1 – tax rate).
Statement 2:	If a company is profitable, the value of its tax shield will be positive and its value will increase as its leverage increases, all else equal.

With respect to Palmer’s statements:

A) both are correct.

B) both are incorrect.

C) only one is correct.

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Palmer’s first statement is incorrect. The calculation Palmer describes is the calculation for the after-tax cost of debt. The value of a tax shield is equal to the marginal tax rate times the amount of debt in the capital structure. Palmer’s second statement is correct. The tax shield adds value to the firm so that the value of a levered firm is greater than the value of an unlevered firm, all else equal.

pacmandefense

Davis Streng, the corporate controller for the Cannizaro Corporation has been researching Modigliani and Miller’s (MM) theories on capital structure. Streng would like to apply the theories to his firm’s capital structure, but does not agree with MM’s assumption of no taxes, since Cannizaro has a 40% tax rate. If Streng removes the assumption of no taxes, but keeps all of MM’s other assumptions, which of the following would be the optimal capital structure for maximizing the value of the firm?

A) The capital structure Streng chooses is irrelevant.

B) 100% equity.

C) 100% debt.

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If MM’s other assumptions are maintained, removing the no tax assumption means that the value of the firm is maximized when the value of the tax shield is maximized, which occurs with a capital structure of 100% debt.

pacmandefense

Katherine Epler, a self-employed corporate finance consultant, is working with her newest client, Harbor Machinery. Epler is discussing various capital structure theories with her client, and makes the following comments.
Comment 1: If we remove the assumption of no taxes from Modigliani and Miller’s theory regarding capital structure, and if the firm holds some proportion of debt, increases in the corporate tax rate will increase the value of the firm.
Comment 2: If we also include the costs of financial distress in Modigliani and Miller’s assumptions, the optimal capital structure will not contain any debt financing.With respect to Epler’s comments:

A) both are correct.

B) both are incorrect.

C) only one is correct.

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Epler’s first comment is correct. The tax deductibility of interest payments provides a tax shield that adds value to the firm. The value of a tax shield is equal to the marginal tax rate times the amount of debt in the capital structure, so the higher the tax rate, the greater the value of the tax shield and the value of the firm, all else equal. Epler’s second comment is incorrect. If the costs of financial distress are also included in MM’s assumptions, we get the static-tradeoff theory, where the firm will have debt in its capital structure up to the point where the marginal cost of financial distress exceeds the marginal value provided by the tax shield.

pacmandefense

Which of the following statements about capital structure theories is most accurate?

A) Based on signaling theory, if a firm issues new common stock it means that the firm thinks future investment prospects are better than normal.

B) In a Modigliani and Miller (MM) world with taxes, but no bankruptcy cost, you would expect to see firms taking on very little debt.

C) In a world with taxes and bankruptcy costs one would expect there to be an optimal capital structure where the cost of capital is minimized and share price is maximized.

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It is true that in a world with taxes and bankruptcy costs there will be an optimal capital structure where the cost of capital is minimized and share price is maximized. The other statements are false. In a tax world without bankruptcy the optimal capital structure is 100% debt. When firms issue new equity, it may suggest investment prospects look poor

pacmandefense

Which of the following statements about a firm's capital structure is least accurate?

A) The optimal capital structure is the one that minimizes the weighted average cost of capital and consequently maximizes the value of the firm's share price.

B) The firm's share price is maximized when the firm maximizes its earnings per share while it minimizes its cost of capital.

C) If bankruptcy costs were included into the M&M analysis of capital structure in a tax world there would be an optimal capital structure between no debt and all debt.

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The optimal capital structure is the one that maximizes stock price and minimizes the WACC. The optimal capital structure is not the one that maximizes the firm’s EPS.