Chapter 16 Debt Policy

Question 1

CAPITAL STRUCTURE

Answer 1

Mix of long-term debt and equity financing

Question 2

RESTRUCTURING

Answer 2

Process of changing the firm’s capital structure without changing its real assets

Question 3

MODIGLIANI AND MILLER (MM) PROPOSITIONS

Answer 3

Under assumptions of no taxes and no bankruptcy costs:

1) Value of a firm doesn’t depend on its capital structure
2) Cost of equity increases when the debt-equity ratio increases
- -> firms can create value by using debt financing

Question 4

OPERATING RISK

Answer 4

Risk in the firm’s operating income

Question 5

FINANCIAL RISK

Answer 5

Risk to shareholders resulting from the use of debt

Question 6

INTEREST TAX SHIELD

Answer 6

Tax savings resulting from deductibility of interest payments

Question 7

COSTS OF FINANCIAL DISTRESS

Answer 7

Costs arising from bankruptcy or distorted business decisions before bankruptcy

Question 8

LOAN COVENANT

Answer 8

Agreement between a firm and lender requiring the firm to fulfill certain conditions to safeguard the loan (to reassure that the firm plans to pay their debts in times of financial distress)

Question 9

TRADE-OFF THEORY

Answer 9

Debt Equity decisions as trade-off between the benefit of interest tax shield and costs of financial distress

Question 10

PECKING ORDER THEORY

Answer 10

Firms prefer to issue debt rather than equity if internal finance is insufficient