土豆妮

Which of the following best describes the shape of the line depicting the value of a levered firm when plotted according to the static trade-off theory? Assume that the percentage of debt in the capital structure is the independent variable.

A) U shaped.

B) Always upward sloping.

C) Upside down U shaped.

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The line depicting the value of a levered firm according to the static trade-off theory looks like an upside down U. The value of the firm will initially increase due to the tax savings provided by taking on additional debt financing, and then will decline as the costs of financial distress exceed the tax benefits of taking on additional debt financing.

土豆妮

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% debt.

C) 100% equity.

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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.

土豆妮

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 incorrect.

B) Both are correct.

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.

土豆妮

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.

土豆妮

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

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

B) Legal fees paid to bankruptcy lawyers.

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

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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.

土豆妮

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) only one is correct.

C) both are incorrect.

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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.

土豆妮

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.

土豆妮

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.

土豆妮

Bavarian Crème Pies (BCP) has been baking and selling cakes, pies, and other confectionary items for more than 150 years. The company started out, like many firms, as a small Mom and Pop operation. Today the firm has more than 4500 employees at 10 facilities in Germany, France, Belgium, and Holland. BCP’s stock has recently been under considerable pressure, and is trading at a 15-year low. The Bank of Munich, the firm’s primary lender and also a major stockholder, has succeeded in forcing BCP’s CEO into accepting an early retirement package.

The new CEO, Dietmar Schulz, is attempting to turn around the firm’s loss of market value, and reviving the attractiveness of the firm as an investment. BCP’s sales have been strong, growing by more than 5 percent during the past year to a new record. Firm profits, while not growing at the pace he believes that they can, remain positive, and measures of profitability remain within what he considers to be acceptable bounds. Therefore, he believes that the firm’s valuation problem may emanate from the choice of capital structure, which is currently 30 percent equity and 70 percent debt.

Because of their financial interest in the firm, the Bank of Munich has made it clear that they will provide whatever assistance they can to help the effort. Schulz has enlisted the services of one of the bank’s corporate finance team, Katarina Iben, CFA. Iben has advised other bank customers regarding capital structure, and has helped them to devise plans to improve shareholder value. Schulz has begun to prepare a list of topics that he wants to address with Iben when she meets with BCP’s finance staff on Friday.

On the top of the list of questions is the matter of whether or not the sources of a firm’s capital can affect firm value. Schulz recalls that during his days as a master’s degree student at the London School of Economics his professors told about the M and M theories regarding capital structure. As it has been some time since he has thought about these theories, he plans to ask Iben to discuss them with his staff.

Schulz also recalls that many theoretical concepts are based upon assumptions about markets and market frictions. He is concerned that, whatever the outcome of the finance staff’s discussions with Iben, any decisions made by BCP must remain grounded in the real world so that he can defend them to his board and to shareholders. To this end, he plans to foster a discussion with Iben and his staff concerning some of the practical matters that pertain to the firm’s capital structure in the real world.

Three days later Iben has arrived at BCP’s headquarters for the big meeting. Schulz opens the discussion by asking Iben to characterize the main objective concerning capital structure, and how one might go about assessing whether or not BCP was anywhere near meeting this objective.

Which of the following statements correctly characterizes the main objective of the capital structure decision?

A) Maximize firm value.

B) Maximize the WACC.

C) Minimize firm risk.

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The objective of the firm’s capital structure decision should be to maximize firm value. (Study Session 8, LOS 30.a)

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Which of the following statements most correctly characterizes MM proposition 1?

A) Firms have a preference ordering for capital sources, preferring internally-generated equity first, new debt capital second, and externally-sourced equity as a last resort.

B) Increasing the use of relatively lower cost debt causes the required return on equity to increase such that the overall cost of capital is unchanged.

C) Regardless of how the firm is financed, the overall value of the firm and aggregate value of the claims issued to finance it remain the same.

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MM proposition 1 states that regardless of how the firm is financed, the overall value of the firm and aggregate value of the claims issued to finance it remain the same. (Study Session 8, LOS 30.a)

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Which of the following statements most correctly characterizes MM proposition 2?

A) Increasing the use of relatively lower cost debt causes the required return on equity to increase such that the overall cost of capital is unchanged.

B) Firms will seek to use debt financing up to the point that the value of the tax shield benefit is outweighed by the costs of financial distress.

C) Regardless of how the firm is financed, the overall value of the firm and aggregate value of the claims issued to finance it remain the same.

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MM proposition 2 states that increasing the use of relatively lower cost debt causes the required return on equity to increase such that the overall cost of capital is unchanged. (Study Session 8, LOS 30.a)

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Which of the following items is least likely to be a cost that has the potential to influence capital structure decisions?

A) Homogeneous expectations.

B) Agency.

C) Financial distress.

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Financial distress costs, agency costs, and the costs associated with asymmetric information are all factors that have the potential to influence capital structure. Homogeneous expectations is an assumption that underlies the MM capital structure propositions. (Study Session 8, LOS 30.a)

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The main outcome of the static trade-off theory is:

A) there is no optimal capital structure.

B) there is an optimal capital structure.

C) the value of the firm is not affected by the choice of capital structure.

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The main conclusion of the static trade-off theory is that there is an optimal capital structure, and that this is based upon the firm’s characteristics. Firms will seek to use debt financing up to the point that the value of the tax shield benefit is outweighed by the costs of financial distress. The value of the tax shield is a function of the firms’ tax rate, and the costs of financial distress are a function of the nature of the firm’s business. (Study Session 8, LOS 30.a)

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Which of the following factors is least applicable when an analyst is attempting to assess whether a firm’s capital structure is value maximizing?

A) The quality of the firm’s corporate governance.

B) The proximity of the current structure to the stated target.

C) Changes in the structure over time.

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Even if the current structure is consistent with the firm’s stated target capital structure, this does not ensure that it is value maximizing. The other items listed can provide useful information regarding whether the firm’s existing capital structure is optimal. (Study Session 8, LOS 30.d)

土豆妮

Which of the following is likely to encourage a firm to increase the amount of debt in its capital structure?

A) The corporate tax rate increases.

B) The personal tax rate increases.

C) The firm's earnings become more volatile.

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An increase in the corporate tax rate will increase the tax benefit to the corporation, because interest expense is not taxable. An increase in the personal tax rate will not impact the firm’s cost of capital. More volatile earnings increase the risk of the firm and therefore the firm would not desire to increase financial risk as a result of these changes.