Chapter 16

Question 1

Capital structure

Answer 1

firms mix of debt and equity

Question 2

what is business risk

Answer 2

the risk a firms common stockholders would face if the firm had no debt

Question 3

high fixed costs for a firm mean high…

Answer 3

operating leverage

Question 4

if a firm has high operating leverage then it has _______ risk

Answer 4

high

Question 5

when a company has a high degree of operating leverage and there is a relatively small change in sales what does this affect

Answer 5

large change to…
EBIT
NOPAT
return on invested capital (ROIC)

Question 6

higher fixed costs are generally associated with

Answer 6

highly automated capital-intensive firms

a business that employs highly skilled workers

firms with high product development costs

Question 7

when does the operating break-even point occur

Answer 7

when EBIT is equal to zero

Question 8

to figure out the when the operating break even point occurs what formula do you use

Answer 8

EBIT=PQ-VQ-F = 0

Question 9

how do you calculate incremental profits

Answer 9

new profit - old profit

Question 10

business risk vs financial risk

Answer 10

business: essential to a firms operations, causes uncertainty in EBIT, NOPAT, ROIC

financial risk: if a firm uses debt, then the business risk is concentrated on common stock holders, if

Question 11

what do financial and business risk combined determine

Answer 11

total risk of a firms future ROE

Question 11

what does financial leverage magnifie

Answer 11

Return on Equity (ROE) - could be good or bad way

Question 11

what is financial leverage

Answer 11

a firm issuing more debt

Question 12

what do capital structure choices affect

Answer 12

ROE

Question 13

what is the MM-Zero Tax capital structure theory and what are its assumptions

Answer 13

• there are no brokerage costs
• no taxes
• no bankruptcy
• investors can borrow at the same rate as corporations
• all investors have the same information
• EBIT is not affected by use of debt

Question 14

is capital structure relevant in MM Zero Tax Theory

Answer 14

NO

Question 15

what does MM Zero Taxes theory conclude

Answer 15

two firms producing the same cash flows must have the same value

Question 16

What is MM corporate taxes theory

Answer 16

• corporate tax laws make it so interest from debt reduces taxes
• more CF goes to investors and less to taxes
• debt “shields” some of the firms CF from taxes

Question 17

what does the MM Corporate Taxes Theory conclude

Answer 17

• debt adds value to the firm through the reduction of taxes

Question 18

MM Corporate and Personal Taxes theory

Answer 18

personal taxes reduce the advantage of corporate debt

Question 19

what does the MM Personal and corporate taxes theory conclude

Answer 19

use of debt financing remains advantageous, but benefits are less than under only corporate taxes

-firms should still use 100% debt

Question 20

What is the Trade-off Theory

Answer 20

MM theory ignores bankruptcy costs, which increase as more debt is used

Question 21

what is bankruptcy costs

Answer 21

the probability of financial distress

Question 22

in the tradeoff theory if there is low financial leverage levels then…

Answer 22

tax benefits outweigh bankruptcy costs

Question 23

in the tradeoff theory if there is high financial leverage levels then…

Answer 23

bankruptcy costs outweigh tax benefits

Question 24

what is the value of a firm in the trade off theory

Answer 24

value of an unlevered firm (firm with no debt) + the value of any side effects which include tax shield and bankruptcy costs

Question 25

Signaling Theory

Answer 25

managers have more information about the stock

company sells: negative prospects, negative signal

don’t sell: positive prospects

Question 26

a firm with few profitable investments

Answer 26

should use high levels of debt

Question 27

if a firm has a lot of investment opportunities then…

Answer 27

it should reserve borrowing capacity and only issue debt if a good opportunity comes along

Question 28

Pecking order theory

Answer 28

firms start by using internal funds since there is no flotation costs and then if more funds are needed they issue debt and then finally equity since equity has highest flotation costs

Question 29

how does using debt constrain managers

Answer 29

forces discipline on managers to avoid non-value adding acquisitions

Question 30

what is the market timing theory

Answer 30

managers try to time the market when issuing securities

issue equity when markets high

issue debt when market is low and interest rates are low

Question 31

which capital structure theory should managers choose

Answer 31

one that maximizes shareholders wealth

Question 32

What are the steps in analyzing each potential capital structure

Answer 32

1. estimate interest rate
2. estimate cost of equity
3. estimate WAAC
4. estimate Vop

Question 33

what is unlevered beta

Answer 33

beta of a business when a firm has no debt

Question 34

is unlevered beta or regular beta higher

Answer 34

regular since unlevered is less risky

Question 35

what is recapitalizing

Answer 35

a firm issues additional debt to optimize its capital structure and then uses the debt proceeds to repurchase stock

Question 36

What are the steps to recapitalizing

Answer 36

1. The company issues new debt
2. company announces the firm’s intent to repurchase stock
3. company repurchases stock

Question 37

The issuance of debt and the resulting change in the optimal capital
structure causes

Answer 37

1. WAAC decrease
2. VOP to increase
3. Shareholder wealth increase
4. Stock price increases

Question 38

what effects does a stock repurchase have

Answer 38

• ST investments fall since they are used to repurchase stock
• stock price is unchanged
• value of equity falls
• shareholder wealth remains the same