Question 1

Unlike direct bankruptcy costs, indirect costs are not considered transaction costs.

Accepted Answer

Indirect bankruptcy costs, while not fees or expenses paid directly during the bankruptcy process, are still considered a form of transaction costs because they represent the economic costs associated with the difficulties and inefficiencies of going through bankruptcy, such as lost sales, customers, and employee morale.

Question 2

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.

Accepted Answer

M&M Proposition 2, also known as the capital structure irrelevance principle, states that the required rate of return on a firm's common stock is directly related to the riskiness of the firm's assets and is not affected by the firm's choice of capital structure (i.e., debt-to-equity ratio).

Question 3

M&M Proposition 1 assumes that the mix of debt and equity that a firm chooses does not affect real investment policy.

Accepted Answer

M&M Proposition 1 states that the mix of debt and equity that a firm chooses does not affect its total value or cost of capital, assuming perfect markets and no taxes. It does not make any assumptions about real investment policy.

Question 4

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.

Accepted Answer

M&M Proposition 1, also known as the capital structure irrelevance principle, states that the capital structure of a firm does not affect the required rate of return on a firm's assets. M&M Proposition 2, however, states that the cost of equity increases as the firm's leverage increases, meaning that the required rate of return on firm's equity does change with capital structure decisions.

Question 5

The enterprise value of a firm is the value of equity minus the value of debt.

Accepted Answer

The enterprise value of a firm is the value of equity plus the value of debt minus cash and cash equivalents.

Question 6

A financial restructuring can change the value of a firm's real assets, such as plant and equipment.

Accepted Answer

A financial restructuring involves changing a firm's financial structure, such as debt and equity mix, but does not directly affect the value of real assets. However, financial restructuring may enable a firm to invest in or dispose of real assets in a different manner, potentially affecting their value in the long term.

Question 7

Direct-bankruptcy costs are considered transactions costs and occur when a firm must navigate the bankruptcy process.

Accepted Answer

Direct-bankruptcy costs are costs incurred by a firm when going through the bankruptcy process, such as legal fees and administrative expenses. These costs are considered transaction costs as they are directly related to the process of restructuring or liquidating the company.

Question 8

Direct bankruptcy costs are considered small when compared to indirect costs.

Accepted Answer

Direct bankruptcy costs, which include legal and administrative expenses, are generally smaller compared to indirect costs such as loss of customer trust, supplier relationships, and employee morale, which can significantly impact a company's value.

Question 9

Bankruptcy and agency costs both act as limits on the amount of debt in the capital structure.

Accepted Answer

both bankruptcy and agency costs create disincentives for lenders to provide too much debt to a company, as the risk of default and potential conflicts of interest can lead to financial losses.

Question 10

When calculating free cash flow, it is important to include interest and principal payments.

Accepted Answer

Free cash flow is calculated by taking operating cash flow and subtracting capital expenditures; it does not include interest and principal payments as those are financing activities, not operating activities.

Question 11

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.

Accepted Answer

More debt in a firm's capital structure does provide managers with an incentive to maximize cash flows due to the obligation to meet fixed interest payments. However, it does not incentivize them to take on negative NPV projects; rather, it might pressure them to avoid such projects to ensure financial stability and the ability to service the debt.

Question 12

Issuing debt is less expensive than issuing stock.

Accepted Answer

Issuing debt is less expensive than issuing stock because debt typically has a lower cost of capital compared to equity, meaning that the interest payments on debt are usually lower than the dividends paid to stockholders. Additionally, issuing debt does not dilute ownership or voting rights in the company, which can be a concern for existing shareholders.

Question 13

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.

Accepted Answer

When a firm gets closer to financial distress causing expected bankruptcy costs to increase, lenders will often charge the firm a higher interest rate to compensate for the increased risk of default.

Question 14

With no debt, the WACC is the cost of equity plus the required rate of return on the firm's underlying assets.

Accepted Answer

WACC (Weighted Average Cost of Capital) is a weighted average of the cost of equity and the cost of debt. If there is no debt, WACC is simply the cost of equity, not the sum of the cost of equity and the required rate of return on the firm's underlying assets.

Question 15

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.

Accepted Answer

This statement accurately reflects the value of a firm with debt under the M&M assumptions with taxes, which states that the total value of a firm is unaffected by its capital structure. However, the value of a firm with debt can be calculated as the value of the firm without debt plus the present value of the interest tax shield, which arises from the tax deductibility of interest payments on debt. Therefore, this statement is true.

Question 16

A higher fraction of debt indicates a lower degree of financial leverage.

Accepted Answer

A higher fraction of debt indicates a higher degree of financial leverage, as the company is relying more on borrowed funds to finance its operations.

Question 17

Indirect bankruptcy costs include changes in customer and supplier behavior that negatively affect the firm.

Accepted Answer

Indirect bankruptcy costs refer to the negative impact on the firm's relationships with customers and suppliers, which can result in lost business, lower sales, and reduced profitability. These costs can be significant and are often overlooked when considering the overall cost of bankruptcy.

Question 18

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.

Accepted Answer

This statement correctly describes the calculation of the present value of the tax shield. The tax shield is created by the tax deductible interest payments on debt, and its present value can be determined by multiplying the amount of debt outstanding by the relevant tax rate.

Question 19

Indirect bankruptcy costs will often increase when a firm is in financial stress and it may even push the company into bankruptcy.

Accepted Answer

Indirect bankruptcy costs such as loss of customer confidence, supplier disruptions, and employee morale can increase when a firm is in financial distress, ultimately pushing the company into bankruptcy.

Question 20

Minimizing the cost of a firm's financing activities also maximizes the overall value of the firm.

Accepted Answer

Minimizing the cost of financing activities such as obtaining loans or issuing bonds, reduces the firm's cost of capital and increases its profitability, leading to an increase in the overall value of the firm.

Quiz 16: Capital Structure Policy