Question 1

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.

Accepted Answer

The pecking order theory suggests that companies prioritize their sources of financing (from internal financing to equity) according to the principle of least effort, or least resistance, implying no specific target debt-equity ratio but rather a preference for internal over external financing. It does not imply that companies prefer to borrow up to the point where financial distress costs offset the tax benefits of debt; this concept is more closely related to the trade-off theory of capital structure.

Question 2

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

Accepted Answer

The most important factors when determining a target debt-equity ratio are taxes, asset types, and uncertainty of operating income. Taxes play a significant role in determining the cost of debt financing, and asset types affect the risk associated with the financing. The uncertainty of operating income is a major factor in determining the appropriate debt level, as the company needs to be able to cover its debt payments even in times of economic uncertainty. Current operating income and inflation rates are also important, but not as critical as the factors listed in option D. Interest rates and future operating income have a secondary importance in determining the target debt-equity ratio.

Question 3

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.

Accepted Answer

If the personal tax rate on the distribution of income to stockholders is less than the personal tax rate on interest income, it will make the use of corporate debt less attractive as compared to paying out profits as dividends, since stockholders will have to pay a higher tax on the interest income earned from corporate debt as compared to the tax on dividend income. This will result in a preference for paying out dividends, which will lead to a shift away from the use of corporate debt.

Question 4

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.

Accepted Answer

Corporations in the U.S. tend to underutilize debt, meaning they rely less on debt financing compared to other countries. This is due to various reasons such as stronger investor protections and a more developed equity market in the U.S.

Question 5

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

Accepted Answer

The hotel/gaming industry typically has high levels of debt due to the capital-intensive nature of the business, such as building and maintaining hotels and casinos. Additionally, these companies may take on debt to expand their properties or invest in new developments.

Question 6

Ignore financial distress costs.When [(1 − T_C)× (1 − T_S)= (1 − T_B)],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.

Accepted Answer

When the left side of the equation [(1 − T_C)× (1 − T_S)] is equal to the right side of the equation (1 − T_B), the firm is indifferent between issuing debt or issuing equity. This means that the firm does not receive any tax benefits or costs from issuing debt or equity, and can choose either financing option based on other factors such as cost, risk, and availability. Therefore, the best choice is C, tend to be indifferent between issuing debt or issuing equity.

Question 7

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.

Accepted Answer

The bondholders exchanging their bonds for common shares will decrease the firm's debt and increase the number of outstanding shares of common stock. This will result in a decline in the debt-equity ratio. However, the increase in the number of common shares outstanding may dilute the value of existing common shares, leading to a decline in the stock's price. Therefore, both the debt-equity ratio and the stock's price are likely to decline.

Question 8

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.

Accepted Answer

Firms with large investments in tangible assets tend to have higher target debt-equity ratios than firms that primarily invest in intangible assets because tangible assets provide collateral for debt financing, giving lenders more security and increasing their willingness to lend. This higher debt level can lead to higher financial leverage and therefore higher financial distress costs, but this is outweighed by the benefits of using debt financing to invest in tangible assets.

Question 9

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.

Accepted Answer

The pecking order theory suggests that firms should use internal financing first, followed by debt, and finally equity. This is because issuing equity can signal that a firm's stock is overvalued and lead to a decline in the stock price. Additionally, issuing debt can be less costly than issuing equity due to the tax deductibility of interest payments. Internal financing in the form of retained earnings is seen as the most cost-effective source of funds since there are no issuance costs or interest payments.

Question 10

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.

Accepted Answer

Issuing debt creates a commitment to fixed payments, which can incentivize the owner-manager to work harder and reduce shirking and perquisite consumption to ensure the firm meets its debt obligations.

Question 11

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

Accepted Answer

When firms issue more debt, the present value of the tax shield on debt increases because the interest payments on the debt are tax-deductible, leading to tax savings. At the same time, the present value of financial distress costs also increases because higher levels of debt increase the risk of financial distress.

Question 12

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.

Accepted Answer

The free cash flow hypothesis suggests that issuing debt can discipline managers by obligating them to make regular payments to creditors, thus limiting the funds available for potential wasteful spending.

Question 13

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.

Accepted Answer

According to the pecking-order theory, a firm's leverage ratio is primarily determined by its financing needs. This theory suggests that firms will prioritize internal funding, followed by debt, and then equity issuance, in order to meet their financing needs. As such, a firm's leverage ratio will be influenced by the amount of financing it requires to fund its operations, investments, and growth opportunities.

Question 14

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.

Accepted Answer

The answer of A decrease in a firm's level of...

Question 15

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.

Accepted Answer

Capital structures can vary significantly across industries due to differences in financing needs, risk profiles, and access to capital markets. It is not empirically correct to suggest that capital structures are fairly constant across industries.

Question 16

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.

Accepted Answer

The financial staff's advice that the firm's value will decrease if they issue bonds suggests that the firm may have already reached its optimal debt-equity ratio. Adding more debt would cause the firm's value to decrease, indicating that the firm may have already taken on as much debt as it can handle.

Question 17

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.

Accepted Answer

The MM theory assumes that bankruptcy is without cost and that the tax benefits of debt are fully available. In practice, bankruptcy can be a disadvantage to debt, and the tax benefits of debt may be restricted or non-existent due to various factors such as interest rate caps, alternative minimum tax, and thin capitalization rules. As a result, firms may not issue maximum debt as predicted by the MM theory.

Question 18

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.

Accepted Answer

An increase in debt is often seen as a positive signal because it suggests that the firm is confident in its future cash flows and ability to service the debt, indicating potential growth and profitability.

Question 19

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.

Accepted Answer

The answer of In general,U.S.firms:
A)tend to overweigh debt in relation...

Question 20

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.

Accepted Answer

The optimal capital structure of a particular firm can change if tax rates change, as this affects the cost of debt and the overall cost of capital. Therefore, a firm's ideal mix of debt and equity financing may shift as tax rates fluctuate. The other options are incorrect as the optimal capital structure can vary between firms and industries, can change over time due to factors other than an acquisition, places equal emphasis on both operations and financing, and is influenced by changes in financial markets.

Quiz 17: Capital Structure: Limits to the Use of Debt

Which one of the following is not implied by the pecking order theory?

Which three factors are generally considered to be the most important when determining a target debt-equity ratio?

The introduction of personal taxes may reveal a disadvantage to the use of corporate debt if the personal tax rate on:

Corporations in the U.S.,as compared to other countries,tend to:

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?

Ignore financial distress costs.When [(1 − T_C) × (1 − T_S) = (1 − T_B) ],then firms:

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:

Studies have found that firms with large investments in tangible assets tend to have:

The pecking order states that firms should:

Issuing debt instead of new equity in a closely held firm is most apt to cause:

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 .

The free cash flow hypothesis states that:

According to the pecking-order theory,a firm's leverage ratio is determined by:

A decrease in a firm's level of debt tends to imply:

Which one of the following is not empirically correct?

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:

The MM theory with taxes implies that firms should issue maximum debt.In practice,this does not occur because:

Which one of the following statements is true?

In general,U.S.firms:

The optimal capital structure: