Chapter 18 - How Much Should A Corporation Borrow?

Chapter 18 - How Much Should a Corporation Borrow?
Chapter 18
How Much Should a Corporation Borrow?
Multiple Choice Questions
1. The main advantage of debt financing for a firm is:

I) no SEC registration is required for bond issue
II) interest expense of a firm is tax deductible
III) unlevered firms have higher value than levered firms
A. I only
B. II only
C. III only
D. I and III only
2. If a firm permanently borrows $100 million at an interest rate of 8%, what is the present
value of the interest tax shield? (Assume that the tax rate is 30%)
A. $8.00 million
B. $5.6 million
C. $30 million
D. $26.67 million
E. None of the above
3. If a firm borrows $50 million for one year at an interest rate of 10%, what is the present
value of the interest tax shield? Assume a 30% tax rate. (Approximately.)
A. $1.364 million
B. $1.5 million
C. $1.0 million
D. $4.545 million
4. In order to find the present value of the tax shields provided by debt, the discount rate used
is the:
A. cost of capital
B. cost of equity
C. cost of debt
D. none of the above
18-1
5. In order to calculate the tax shields provided by debt, the tax rate used is the:
A. average corporate tax rate
B. marginal corporate tax rate
C. average of shareholders' tax rates
D. average of bondholders' tax rates
value of the interest tax shield? Assume a 30% tax rate.
A. $50.0 million
B. $25.0 million
C. $15.0 million
D. $1.5 million
A. $50.00 million
B. $17.50 million
C. $1.445 million
D. $1.239 million
8. In order to calculate the tax shield effect of interest payment for a corporation, always use
the:
I) average corporate tax rate
II) marginal corporate tax rate
III) state mandated tax rate
A. I only
B. II only
C. III only
D. I and III only
18-2
9. If a corporation cannot use its interest payments to get tax shield for a particular year
because it has suffered a loss, it is still possible to get the tax shield because of the:
I) carry back provision that allows corporations to carry back the loss and receive a tax refund
up to the amount of taxes paid in the previous two years.
II) carry forward provision that allows corporations to carry forward the loss and use it to
shield income in subsequent years.
A. I only
B. II only
C. I and II
10. The reason that MM Proposition I does not hold good in the presence of corporate taxes is
because:
A. Levered firms pay lower taxes when compared with identical unlevered firms
B. Bondholders require higher rates of return compared with stockholders
C. Earnings per share are no longer relevant with taxes
D. Dividends are no longer relevant with taxes
11. The positive value to the firm by adding debt to the capital structure in the presence of
corporate taxes is:
I) Due to the extra cash flow going to the investors of the firm rather than the tax authorities
II) Due to the earnings before interest and taxes being fully taxed at the corporate rate
III) Because personal-tax rates are the same as corporate tax rates
A. I only
B. II only
C. III only
D. II and III only
18-3
12. MM Proposition I with corporate taxes states that:

I) Capital structure can affect firm value by an amount that is equal to the present value of the
interest tax shield
II) By raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its
total value
III) Firm value is maximized at an all debt capital structure
A. I only
B. II only
C. III only
D. I, II, and III
13. Bombay Company's balance sheet is as follows:

(NWC = net working capital; LTA = long term assets; D = debt; E = equity; V = firm value):
According to MM's Proposition I corrected for taxes, what will be the change in company
value if Bombay issues $200 of equity and uses it to make a permanent reduction in the
company's debt? Assume a 35% tax rate.
A. +$140
B. +$70
C. $0
D. -$70
14. MM's Proposition I corrected for the inclusion of corporate income taxes is expressed as:
A. VL = VU
B. VL = VU + D(1 - TC)
C. VL = VU + (TC)(D)
D. VU = VL + (TC)(D)
15. Assuming that bonds are sold at a fair price, the benefits from the tax shield go to the:
A. managers of the firm
B. bondholders of the firm
C. stockholders of the firm
D. lawyers of the firm
18-4
16. Assume the corporate tax rate is 30%. The firm has no debt in its capital structure. It is
valued at $100 million. What would be the value of the firm if it issued $50 in perpetual debt
and repurchased the equity?
A. $65
B. $115
C. $100
D. None of the above
17. The relative tax advantage of debt with personal and corporate taxes is: Where: TC =
Corporate tax rate; TpE = Personal tax rate on equity income; and Tp = Personal tax rate on
interest income.
A.
B.
C.
D.
(Corporate tax rate) = 35%; TpE = Personal tax rate on equity income = 30%; and Tp =
Personal tax rate on interest income = 20%: (approximately)
A. 1.76
B. 1.16
C. 1.35
D. None of the given ones
19. For every dollar of operating income paid out as interest, the bondholder realizes:
A. (1 - Tp)
B. (1 - TpE) (1 - TC)
C. (1 - TC)
18-5
20. For every dollar of operating income paid out as equity income, the shareholder realizes:
A. (1 - Tp)
B. (1 - TpE) (1 - TC)
C. (1 - TC)
21. Suppose that a company can direct $1 to either debt interest or capital gains for equity
investors. If there were no personal taxes on capital gains, which of the following investors
would not care how the money was channeled? (The corporate tax rate is 35%)
A. Investors paying personal tax of 17.5%
B. Investors paying personal tax of 35%
C. Investors paying personal tax of 53%
22. In Miller's model, when the quantity (1 - TC)(1 - TpE) = (1 - Tp), then:
A. The firm should hold no debt
B. The value of the levered firm is greater than the value of the unlevered firm
C. The tax shield on debt is exactly offset by higher personal taxes paid on interest income
investors. If half of equity income were subject to personal tax (e.g.: half is taxable dividends
and half is tax-free capital gains) which investor would not care how the money is channeled?
(The corporate tax rate is 35%)
A. Investors paying zero personal tax
B. Investors paying a personal tax rate of 53%
C. Investors paying a personal tax rate of 17.5%
Given the following information, leverage will add how much value to the unlevered firm per
dollar of debt?
18-6
24. (Approximately) Corporate tax rate: 34% Personal tax rate on income from bonds: 30%
Personal tax rate on income from stocks: 20%
A. $0.66
B. $0.25
C. -$0.66
D. -$0.34
25. Corporate tax rate: 34% Personal tax rate on income from bonds: 40% Personal tax rate on
income from stocks: 30%
A. $0.246
B. $0.340
C. $0.006
D. $0.23
A. -$0.188
B. $0.340
C. $0.633
27. In Miller's model, when Personal tax rate on income from bonds is equal to the personal
tax rate on income from stocks:
A. relative advantage of debt depends only on the corporate tax rate
B. relative advantage of debt depends only on the personal tax rate on interest income
C. relative advantage of debt depends only on the personal tax rate on income from equity
18-7
28. The MM theory with taxes implies that firms should issue maximum debt. In practice, this
is not true because:
I) Debt is more risky than equity
II) Bankruptcy and its attendant costs is a disadvantage to debt
III) The payment of personal taxes may offset the tax benefit of debt
A. I only
B. II only
C. III only
D. II and III only
29. Although the use of debt provides tax benefits to the firm, debt also puts pressure on the
firm to:
I) Meet interest and principal payments which if not met can put the company into financial
distress
II) Make dividend payments which if not met can put the company into financial distress
III) Meet both interest and dividend payments which when met increase the firm cash flow
IV) Meet increased tax payments thereby increasing firm value
A. I only
B. II only
C. II and III only
D. III and IV only
30. The costs of financial distress depend on the:

I) probability of financial distress
II) corporate and personal tax rates
III) the magnitude of costs encountered if financial distress occurs
A. I only
B. I and II only
C. I, II and III
D. I and III only
18-8
31. The value of the firm in the presence of debt may risk financial distress. Bankruptcy, the
most severe type of financial distress, has an impact on value by:
I) the risk or probability that it may occur
II) the level of risk aversion investors have to debt
III) the total value of the firm being siphoned off to cover bankruptcy costs
A. I only
B. I and II only
C. III only
D. II only
32. When financial distress is a possibility, the value of a levered firm consists of:
I) value of the firm if all-equity-financed
II) present value of tax shield
III) present value of costs of financial distress
IV) present value of omitted dividend payments
A. I only
B. I + II
C. I + II - III
D. I + II - III - IV
33. According to the trade-off theory of capital structure:

A. optimal capital structure is reached when the present value of tax savings on account of
additional borrowing is just offset by increases in the present value of costs of distress.
B. optimal capital structure is reached when stockholders' right to default is balanced by the
the bondholders' right to get interest and principal payments.
C. optimal capital structure is reached when the benefits of limited liability is just offset by
the value of the lawyers' claim.
34. Indirect costs of bankruptcy are borne principally by:

A. Bondholders
B. Stockholders
C. Managers
D. The federal government
18-9
35. Which of the following statement(s) about financial distress is(are) true:
I) always ends in bankruptcy
II) firms can postpone bankruptcy for many years
III) ultimately the firm may recover and avoid bankruptcy altogether
A. I only
B. II only
C. II and III only
D. III only
36. What are some of the possible consequences of financial distress?

I) Bondholders, who face the prospect of getting only part of their money back, are likely to
want the company to take additional risks.
II) Equity investors would like the company to cut its dividend payments to conserve cash.
III) Equity investors would like the firm to shift toward riskier lines of business.
A. I only
B. II only
C. III only
D. I and II only
37. Risk shifting implies:

A. When faced with bankruptcy, managers tend to invest in high risk, high return projects
B. When faced with bankruptcy, managers do not invest more equity capital
C. When faced with bankruptcy; managers may make accounting changes to conceal the true
extent of the problem
D. All of the above
38. When faced with financial distress; managers of firms acting on behalf of their
shareholders' interests will:
A. favor high risk, high return projects even if they have negative NPV
B. refuse to invest in low risk, low return projects with positive NPVs
C. delay the onset of bankruptcy as long as they can
D. all of the above
18-10
A. favor issuing large quantity of low quality debt to low quantity of high quality debt
B. favor paying high dividends to the shareholders
D. all of the above
40. One of the indirect costs to bankruptcy is the incentive toward under investment.
Following this strategy may result in:
I) the firm always choosing projects with the positive NPVs
II) stockholders turning down low risk low return but positive NPV projects
III) stockholders would declare and receive high cash dividends
A. I only
B. II only
C. III only
D. II and III only
41. When shareholders pursue selfish strategies such as taking large risks or paying excessive
dividends, these will result in:
I) no action by debtholders since these are equity holder concerns
II) positive agency costs, as bondholders impose various restrictions and covenants, which
will diminish firm value
III) investments of the same risk class that the firm is in
A. I only
B. II only
C. III only
D. I and III only
42. Inclusion of restrictions in the bond contract leads to:

A. Higher agency costs
B. Higher bankruptcy costs
C. Higher interest costs
D. None the above
18-11
43. The trade-off theory of capital structure predicts that:

A. Unprofitable firms should borrow more than profitable ones
B. Safe firms should borrow more than risky ones
C. Rapidly growing firms should borrow more than mature firms
D. Increasing leverage increases firm value
44. The pecking order theory of capital structure predicts that:

A. If two firms are equally profitable, the more rapidly growing firm will borrow more, other
things equal
B. Firms prefer equity to debt financing
C. Risky firms will end up borrowing less
D. Risky firms will end up borrowing more
45. The pecking order theory of capital structure implies that:

I) Risky firms will end up borrowing more
II) Firms prefer internal finance
III) Firms prefer debt to equity when external financing is required
A. I only
B. II only
C. II and III only
D. III only
46. According to Rajan and Zingales study, debt ratios of individual companies depend on:
I) Size: Large firms have higher debt ratios.
II) Tangible assets: Firms with high ratios of fixed assets to total assets have higher debt
ratios.
III) Profitability: More profitable firms have lower debt ratios.
IV) Market to book: Firms with higher ratios of market-to-book value have lower debt ratios.
V) Market structure: Firms with monopoly power have higher debt ratios.
A. I and II only
B. I, II and III only
C. I, II, III and IV only
D. I, II, III, IV and V
18-12
47. Financial slack includes:

I) Cash
II) Marketable securities
III) Readily salable real assets
IV) Ready access to debt markets or bank loans
A. I only
B. IV only
C. III only
D. I, II, III, and IV
48. What signal is sent to the market when a firm decides to issue new stock to raise capital?
A. Bond markets are overpriced
B. Bond markets are underpriced
C. Stock price is too low
D. Stock price is too high
49. Under the trade off theory, how will a government loan guarantee impact financing?
A. Prefer to issue debt
B. Prefer to issue stock
C. Prefer internal money
D. No impact
True / False Questions
50. The present value of the interest tax shield is the same regardless of whether the firm
plans to borrow permanently or temporarily.
True False
51. Always use the average corporate tax rate to calculate the tax shields for firms.
True False
18-13
52. MM's Proposition I corrected for corporate taxes states that: Value of levered firm =
Value (all equity financed) + PV tax shield.
True False
53. The value of a levered firm is given by:

Value of levered firm = Value (all equity financed) + (TC) * (D) This assumes that the debt is
perpetual debt.
True False
54. Personal taxes on interest income and equity income will always increase the advantage of
debt to a firm.
True False
55. When (1 - Tp) = (1 - TpE)(1 - TC), corporate and personal taxes cancel to make debt policy
irrelevant.
True False
56. Financial distress occurs when promises to creditors are not honored or honored with great
difficulty.
True False
57. When cost of financial distress is included, the value of a levered firm is given by: Value
of levered firm = Value (all equity financed) + PV (tax shield) - PV (costs of financial
distress).
True False
58. The right to default is valuable for the stockholders of firms.

True False
18-14
59. Financial distress always results in bankruptcy.

True False
60. Risk shifting, refusing to contribute equity and playing for time are some of the
consequences of firms facing bankruptcy.
True False
61. According to the trade-off theory, more profitable firms should have more debt and thus
the highest debt ratios.
True False
62. The pecking order theory implies that firms prefer internal to external financing.
True False
63. The existing tax code encourages a preference for equity over debt in corporate financing.
True False
64. A firm bankrupt from excess use of debt, which receives government bailout funds and
government loan guarantees is incentivized to issue more high risk debt.
True False
Short Answer Questions
65. Briefly explain how interest tax shields contribute to the value of stockholders' equity.
18-15
66. State Modigliani-Miller's proposition I corrected to include corporate income taxes.
67. Discuss the basic idea behind Miller's arguments about debt and taxes.
68. What is the relative tax advantage of debt when corporate and personal taxes are
considered?
69. State how the present value of tax shield is changed when personal taxes are included.
18-16
70. How does Modigliani-Miller's proposition I is modified when taxes and financial distress
costs are considered?
71. Briefly explain bankruptcy costs.
72. Discuss some examples of the conflicts of interest that may arise between bondholders
and stockholders when a firm is in financial distress.
73. Briefly explain the trade-off theory of capital structure.
18-17
74. Explain the pecking order theory of capital structure.
75. Explain the impact of government loan guarantees on corporate financing.
18-18
Chapter 18 How Much Should a Corporation Borrow? Answer Key
Multiple Choice Questions
1. The main advantage of debt financing for a firm is:

I) no SEC registration is required for bond issue
II) interest expense of a firm is tax deductible
III) unlevered firms have higher value than levered firms
A. I only
B. II only
C. III only
D. I and III only
Type: Medium
value of the interest tax shield? (Assume that the tax rate is 30%)
A. $8.00 million
B. $5.6 million
C. $30 million
D. $26.67 million
PV of interest tax shield = (0.3)(100) = $30 million
Type: Medium
18-19
value of the interest tax shield? Assume a 30% tax rate. (Approximately.)
A. $1.364 million
B. $1.5 million
C. $1.0 million
D. $4.545 million
PV of interest tax shield = ((0.3)(50)(0.1))/1.1 = $1.364
Type: Difficult
4. In order to find the present value of the tax shields provided by debt, the discount rate used
is the:
A. cost of capital
B. cost of equity
C. cost of debt
Type: Difficult
5. In order to calculate the tax shields provided by debt, the tax rate used is the:
A. average corporate tax rate
B. marginal corporate tax rate
C. average of shareholders' tax rates
D. average of bondholders' tax rates
Type: Medium
18-20
A. $50.0 million
B. $25.0 million
C. $15.0 million
D. $1.5 million
PV of interest tax shield = (0.30)(50) = $15.0 million
Type: Medium
A. $50.00 million
B. $17.50 million
C. $1.445 million
D. $1.239 million
PV of interest tax shield = [(0.3)(50)(0.09)]/1.09 = $1.445 million
Type: Difficult
8. In order to calculate the tax shield effect of interest payment for a corporation, always use
the:
I) average corporate tax rate
II) marginal corporate tax rate
III) state mandated tax rate
A. I only
B. II only
C. III only
D. I and III only
Type: Medium
18-21
9. If a corporation cannot use its interest payments to get tax shield for a particular year
because it has suffered a loss, it is still possible to get the tax shield because of the:
I) carry back provision that allows corporations to carry back the loss and receive a tax refund
up to the amount of taxes paid in the previous two years.
II) carry forward provision that allows corporations to carry forward the loss and use it to
shield income in subsequent years.
A. I only
B. II only
C. I and II
Type: Difficult
10. The reason that MM Proposition I does not hold good in the presence of corporate taxes is
because:
A. Levered firms pay lower taxes when compared with identical unlevered firms
B. Bondholders require higher rates of return compared with stockholders
C. Earnings per share are no longer relevant with taxes
D. Dividends are no longer relevant with taxes
Type: Easy
11. The positive value to the firm by adding debt to the capital structure in the presence of
corporate taxes is:
I) Due to the extra cash flow going to the investors of the firm rather than the tax authorities
II) Due to the earnings before interest and taxes being fully taxed at the corporate rate
III) Because personal-tax rates are the same as corporate tax rates
A. I only
B. II only
C. III only
D. II and III only
Type: Medium
18-22
12. MM Proposition I with corporate taxes states that:

I) Capital structure can affect firm value by an amount that is equal to the present value of the
interest tax shield
II) By raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its
total value
III) Firm value is maximized at an all debt capital structure
A. I only
B. II only
C. III only
D. I, II, and III
Type: Difficult
13. Bombay Company's balance sheet is as follows:

(NWC = net working capital; LTA = long term assets; D = debt; E = equity; V = firm value):
According to MM's Proposition I corrected for taxes, what will be the change in company
value if Bombay issues $200 of equity and uses it to make a permanent reduction in the
company's debt? Assume a 35% tax rate.
A. +$140
B. +$70
C. $0
D. -$70
PV of tax shield = -200 (0.35) = -$70 million
Type: Difficult
14. MM's Proposition I corrected for the inclusion of corporate income taxes is expressed as:
A. VL = VU
B. VL = VU + D(1 - TC)
C. VL = VU + (TC)(D)
D. VU = VL + (TC)(D)
Type: Medium
18-23
15. Assuming that bonds are sold at a fair price, the benefits from the tax shield go to the:
A. managers of the firm
B. bondholders of the firm
C. stockholders of the firm
D. lawyers of the firm
Type: Medium
16. Assume the corporate tax rate is 30%. The firm has no debt in its capital structure. It is
valued at $100 million. What would be the value of the firm if it issued $50 in perpetual debt
and repurchased the equity?
A. $65
B. $115
C. $100
VU = 100; (TC)(B) = 0.3(50) = 15; VL = VU + TCB = 100 + 15 = $115
Type: Medium
Corporate tax rate; TpE = Personal tax rate on equity income; and Tp = Personal tax rate on
interest income.
A.
B.
C.
D.
Type: Medium
18-24
(Corporate tax rate) = 35%; TpE = Personal tax rate on equity income = 30%; and Tp =
Personal tax rate on interest income = 20%: (approximately)
A. 1.76
B. 1.16
C. 1.35
D. None of the given ones
Relative advantage = (1 - 0.2)/[(1 - 0.3)(1 - 0.35)] = 1.76
Type: Difficult
19. For every dollar of operating income paid out as interest, the bondholder realizes:
A. (1 - Tp)
B. (1 - TpE) (1 - TC)
C. (1 - TC)
Type: Medium
20. For every dollar of operating income paid out as equity income, the shareholder realizes:
A. (1 - Tp)
B. (1 - TpE) (1 - TC)
C. (1 - TC)
Type: Medium
18-25
investors. If there were no personal taxes on capital gains, which of the following investors
would not care how the money was channeled? (The corporate tax rate is 35%)
A. Investors paying personal tax of 17.5%
B. Investors paying personal tax of 35%
C. Investors paying personal tax of 53%
Type: Difficult
22. In Miller's model, when the quantity (1 - TC)(1 - TpE) = (1 - Tp), then:
A. The firm should hold no debt
B. The value of the levered firm is greater than the value of the unlevered firm
C. The tax shield on debt is exactly offset by higher personal taxes paid on interest income
Type: Difficult
investors. If half of equity income were subject to personal tax (e.g.: half is taxable dividends
and half is tax-free capital gains) which investor would not care how the money is channeled?
(The corporate tax rate is 35%)
A. Investors paying zero personal tax
B. Investors paying a personal tax rate of 53%
C. Investors paying a personal tax rate of 17.5%
Type: Difficult
Given the following information, leverage will add how much value to the unlevered firm per
dollar of debt?
18-26
24. (Approximately) Corporate tax rate: 34% Personal tax rate on income from bonds: 30%
Personal tax rate on income from stocks: 20%
A. $0.66
B. $0.25
C. -$0.66
D. -$0.34
[1 - ((1 - TC)(1 - TpE)/(1 - Tp))]D = [1 - ((0.66)(1 - 0.2)/(1 0.3)]D = 0.25D; $0.25
Type: Difficult
A. $0.246
B. $0.340
C. $0.006
D. $0.23
[1 - ((1 - TC)(1 - TpE)/(1 - Tp))]D = [1 - ((0.66)(0.7)/0.6]D = 0.23D; $0.23
Type: Difficult
A. -$0.188
B. $0.340
C. $0.633
[1 - ((1 - 0.34)(1 - 0.5)/(1 - 0.1))] = 1 - (0.33/0.9) = 1 - 0.3667 = 0.6333
Type: Difficult
18-27
27. In Miller's model, when Personal tax rate on income from bonds is equal to the personal
tax rate on income from stocks:
A. relative advantage of debt depends only on the corporate tax rate
B. relative advantage of debt depends only on the personal tax rate on interest income
C. relative advantage of debt depends only on the personal tax rate on income from equity
Type: Medium
28. The MM theory with taxes implies that firms should issue maximum debt. In practice, this
is not true because:
I) Debt is more risky than equity
II) Bankruptcy and its attendant costs is a disadvantage to debt
III) The payment of personal taxes may offset the tax benefit of debt
A. I only
B. II only
C. III only
D. II and III only
Type: Medium
29. Although the use of debt provides tax benefits to the firm, debt also puts pressure on the
firm to:
I) Meet interest and principal payments which if not met can put the company into financial
distress
II) Make dividend payments which if not met can put the company into financial distress
III) Meet both interest and dividend payments which when met increase the firm cash flow
IV) Meet increased tax payments thereby increasing firm value
A. I only
B. II only
C. II and III only
D. III and IV only
Type: Difficult
18-28
30. The costs of financial distress depend on the:

I) probability of financial distress
II) corporate and personal tax rates
III) the magnitude of costs encountered if financial distress occurs
A. I only
B. I and II only
C. I, II and III
D. I and III only
Type: Medium
31. The value of the firm in the presence of debt may risk financial distress. Bankruptcy, the
most severe type of financial distress, has an impact on value by:
I) the risk or probability that it may occur
II) the level of risk aversion investors have to debt
III) the total value of the firm being siphoned off to cover bankruptcy costs
A. I only
B. I and II only
C. III only
D. II only
Type: Difficult
32. When financial distress is a possibility, the value of a levered firm consists of:
I) value of the firm if all-equity-financed
II) present value of tax shield
III) present value of costs of financial distress
IV) present value of omitted dividend payments
A. I only
B. I + II
C. I + II - III
D. I + II - III - IV
Type: Medium
18-29
33. According to the trade-off theory of capital structure:

A. optimal capital structure is reached when the present value of tax savings on account of
additional borrowing is just offset by increases in the present value of costs of distress.
B. optimal capital structure is reached when stockholders' right to default is balanced by the
the bondholders' right to get interest and principal payments.
C. optimal capital structure is reached when the benefits of limited liability is just offset by
the value of the lawyers' claim.
Type: Difficult
34. Indirect costs of bankruptcy are borne principally by:

A. Bondholders
B. Stockholders
C. Managers
D. The federal government
Type: Easy
35. Which of the following statement(s) about financial distress is(are) true:
I) always ends in bankruptcy
II) firms can postpone bankruptcy for many years
III) ultimately the firm may recover and avoid bankruptcy altogether
A. I only
B. II only
C. II and III only
D. III only
Type: Medium
18-30
36. What are some of the possible consequences of financial distress?

I) Bondholders, who face the prospect of getting only part of their money back, are likely to
want the company to take additional risks.
II) Equity investors would like the company to cut its dividend payments to conserve cash.
III) Equity investors would like the firm to shift toward riskier lines of business.
A. I only
B. II only
C. III only
D. I and II only
Type: Difficult
37. Risk shifting implies:

A. When faced with bankruptcy, managers tend to invest in high risk, high return projects
B. When faced with bankruptcy, managers do not invest more equity capital
C. When faced with bankruptcy; managers may make accounting changes to conceal the true
extent of the problem
D. All of the above
Type: Difficult
A. favor high risk, high return projects even if they have negative NPV
B. refuse to invest in low risk, low return projects with positive NPVs
D. all of the above
Type: Difficult
18-31
A. favor issuing large quantity of low quality debt to low quantity of high quality debt
B. favor paying high dividends to the shareholders
D. all of the above
Type: Difficult
40. One of the indirect costs to bankruptcy is the incentive toward under investment.
Following this strategy may result in:
I) the firm always choosing projects with the positive NPVs
II) stockholders turning down low risk low return but positive NPV projects
III) stockholders would declare and receive high cash dividends
A. I only
B. II only
C. III only
D. II and III only
Type: Difficult
41. When shareholders pursue selfish strategies such as taking large risks or paying excessive
dividends, these will result in:
I) no action by debtholders since these are equity holder concerns
II) positive agency costs, as bondholders impose various restrictions and covenants, which
will diminish firm value
III) investments of the same risk class that the firm is in
A. I only
B. II only
C. III only
D. I and III only
Type: Medium
18-32
42. Inclusion of restrictions in the bond contract leads to:

A. Higher agency costs
B. Higher bankruptcy costs
C. Higher interest costs
D. None the above
Type: Medium
43. The trade-off theory of capital structure predicts that:

A. Unprofitable firms should borrow more than profitable ones
B. Safe firms should borrow more than risky ones
C. Rapidly growing firms should borrow more than mature firms
D. Increasing leverage increases firm value
Type: Medium
44. The pecking order theory of capital structure predicts that:

A. If two firms are equally profitable, the more rapidly growing firm will borrow more, other
things equal
B. Firms prefer equity to debt financing
C. Risky firms will end up borrowing less
D. Risky firms will end up borrowing more
Type: Medium
45. The pecking order theory of capital structure implies that:

I) Risky firms will end up borrowing more
II) Firms prefer internal finance
III) Firms prefer debt to equity when external financing is required
A. I only
B. II only
C. II and III only
D. III only
Type: Medium
18-33
46. According to Rajan and Zingales study, debt ratios of individual companies depend on:
I) Size: Large firms have higher debt ratios.
II) Tangible assets: Firms with high ratios of fixed assets to total assets have higher debt
ratios.
III) Profitability: More profitable firms have lower debt ratios.
IV) Market to book: Firms with higher ratios of market-to-book value have lower debt ratios.
V) Market structure: Firms with monopoly power have higher debt ratios.
A. I and II only
B. I, II and III only
C. I, II, III and IV only
D. I, II, III, IV and V
Type: Medium
47. Financial slack includes:

I) Cash
II) Marketable securities
III) Readily salable real assets
IV) Ready access to debt markets or bank loans
A. I only
B. IV only
C. III only
D. I, II, III, and IV
Type: Difficult
48. What signal is sent to the market when a firm decides to issue new stock to raise capital?
A. Bond markets are overpriced
B. Bond markets are underpriced
C. Stock price is too low
D. Stock price is too high
Type: Medium
18-34
49. Under the trade off theory, how will a government loan guarantee impact financing?
A. Prefer to issue debt
B. Prefer to issue stock
C. Prefer internal money
D. No impact
Type: Medium
True / False Questions
50. The present value of the interest tax shield is the same regardless of whether the firm
plans to borrow permanently or temporarily.
FALSE
Type: Easy
51. Always use the average corporate tax rate to calculate the tax shields for firms.
FALSE
Type: Easy
52. MM's Proposition I corrected for corporate taxes states that: Value of levered firm =
Value (all equity financed) + PV tax shield.
TRUE
Type: Medium
53. The value of a levered firm is given by:

Value of levered firm = Value (all equity financed) + (TC) * (D) This assumes that the debt is
perpetual debt.
TRUE
Type: Medium
18-35
54. Personal taxes on interest income and equity income will always increase the advantage of
debt to a firm.
FALSE
Type: Medium
55. When (1 - Tp) = (1 - TpE)(1 - TC), corporate and personal taxes cancel to make debt policy
irrelevant.
TRUE
Type: Medium
56. Financial distress occurs when promises to creditors are not honored or honored with great
difficulty.
TRUE
Type: Medium
57. When cost of financial distress is included, the value of a levered firm is given by: Value
of levered firm = Value (all equity financed) + PV (tax shield) - PV (costs of financial
distress).
TRUE
Type: Medium
58. The right to default is valuable for the stockholders of firms.

TRUE
Type: Medium
18-36
59. Financial distress always results in bankruptcy.

FALSE
Type: Medium
60. Risk shifting, refusing to contribute equity and playing for time are some of the
consequences of firms facing bankruptcy.
TRUE
Type: Medium
61. According to the trade-off theory, more profitable firms should have more debt and thus
the highest debt ratios.
TRUE
Type: Medium
62. The pecking order theory implies that firms prefer internal to external financing.
TRUE
Type: Medium
63. The existing tax code encourages a preference for equity over debt in corporate financing.
FALSE
Type: Medium
64. A firm bankrupt from excess use of debt, which receives government bailout funds and
government loan guarantees is incentivized to issue more high risk debt.
TRUE
Type: Medium
18-37
Short Answer Questions
65. Briefly explain how interest tax shields contribute to the value of stockholders' equity.
Generally, levered firms pay less tax than equivalent unlevered firms. The savings in taxes is
called the interest tax shield. Firms can deduct interest payments as expenses, thereby
reducing the level of taxable income. Hence levered firms have lower tax payments. This in
turn increases the value of the firm.
Type: Difficult
66. State Modigliani-Miller's proposition I corrected to include corporate income taxes.
The value of a levered firm is equal to the value of an equivalent unlevered firm plus the
present value of tax shields. In the special case of permanent debt: VL = VU + (TC)(D) Where
TC = Corporate tax rate.
Type: Medium
67. Discuss the basic idea behind Miller's arguments about debt and taxes.
In equilibrium, taxes determine the aggregate amount of corporate debt but not the amount
issued by any particular firm. For a given set of tax rates, both corporate and personal, the
market will adjust until there is no advantage to any firm issuing more debt.
Type: Difficult
18-38
68. What is the relative tax advantage of debt when corporate and personal taxes are
considered?
The relative tax advantage of debt can be stated as: (1 - TP)/[(1 - TC)(1 - TPE)] Suppose all
equity income is in the form of dividends then TPE = TP, the relative tax advantage of debt is:
1/(1 - TC) In case (1 - TP) = (1 - TC)(1 - TPE), the relative tax advantage is zero.
Type: Difficult
69. State how the present value of tax shield is changed when personal taxes are included.
Miller developed a modified form of proposition I by including personal taxes on equity

income and interest income. These could be different from corporate taxes.
VL = VU + [(1 - (1 - TC)(1 - TPE)/(1 - TP)](D)
Where: TC = Corporate tax rate, TPE = personal tax rate on income from equity and TP =
personal tax rate on interest income.
Type: Difficult
70. How does Modigliani-Miller's proposition I is modified when taxes and financial distress
costs are considered?
Financial distress occurs when bondholder contracts are broken or fulfilled with great
difficulty. Financial distress could lead to bankruptcy. Financial distress is costly. This is
reflected in the market value of the levered firm.
Value of a levered firm = Value of an equivalent unlevered firm + PV(tax shield) - PV(cost of
financial distress)
Type: Difficult
18-39
71. Briefly explain bankruptcy costs.
There are direct and indirect costs to bankruptcy. Direct costs include legal and administrative
costs of liquidation or reorganization. Indirect costs of financial distress include impaired
ability to conduct business and increased agency costs. Agency costs associated with
managerial actions under the threat of bankruptcy are: risk shifting, under-investment or
refusal to invest more equity, and milking the property.
Type: Difficult
72. Discuss some examples of the conflicts of interest that may arise between bondholders
and stockholders when a firm is in financial distress.
When a firm is in distress, the shareholders are interested in protecting the value of their
securities and hence take actions that might decrease the value of the firm and hence reduce
the debtholders' wealth. Some examples of such actions are risk shifting, refusing to
contribute equity capital, milking the assets, playing for time and bait and switch.
Type: Medium
73. Briefly explain the trade-off theory of capital structure.
A firm's debt-equity decision can be thought of as a trade-off between interest tax shields and
the costs of financial distress. These two interact to provide an optimal capital structure for a
firm. This is called the trade-off theory.
Type: Medium
18-40
74. Explain the pecking order theory of capital structure.
This theory is based on the observation that, in general, managers know more about the firm's
prospects, risks, and values than do outsiders. This asymmetric information affects the choice
between internal and external financing and between new issues of debt and equity. The
implication is that firms prefer internal financing to external financing. When firms are
propelled to go for external financing it prefers debt to equity.
Type: Medium
75. Explain the impact of government loan guarantees on corporate financing.
The capital markets naturally punish firms for excess use of debt via default and bankruptcy.
Firms naturally will turn away from debt financing and back towards equity financing.
Intervention in the capital markets by the government to provide loan guarantees to firms on
the brink of failure works in the opposite direction by encouraging further leveraging.
Type: Medium
18-41

Chapter 18 - How Much Should A Corporation Borrow?

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Chapter 18 - How Much Should A Corporation Borrow?

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Chapter 18 - How Much Should a Corporation Borrow?

Multiple Choice Questions

1. The main advantage of debt financing for a firm is:

12. MM Proposition I with corporate taxes states that:

13. Bombay Company's balance sheet is as follows:

30. The costs of financial distress depend on the:

33. According to the trade-off theory of capital structure:

34. Indirect costs of bankruptcy are borne principally by:

36. What are some of the possible consequences of financial distress?

37. Risk shifting implies:

42. Inclusion of restrictions in the bond contract leads to:

43. The trade-off theory of capital structure predicts that:

44. The pecking order theory of capital structure predicts that:

45. The pecking order theory of capital structure implies that:

47. Financial slack includes:

True / False Questions

53. The value of a levered firm is given by:

58. The right to default is valuable for the stockholders of firms.

59. Financial distress always results in bankruptcy.

Short Answer Questions

66. State Modigliani-Miller's proposition I corrected to include corporate income taxes.

71. Briefly explain bankruptcy costs.

73. Briefly explain the trade-off theory of capital structure.

74. Explain the pecking order theory of capital structure.

75. Explain the impact of government loan guarantees on corporate financing.