Capital Structure: Limits to the Use of Debt

What is the primary difference between bankruptcy risk and bankruptcy cost, as illustrated by the comparison of Day Corporation and Knight Corporation in a recession scenario without explicit bankruptcy costs?

Which of the following is considered a direct cost of financial distress?

A firm near bankruptcy is considering two mutually exclusive projects. The low-risk project yields firm values of $100 in a recession and $200 in a boom. The high-risk project yields firm values of $50 in a recession and $240 in a boom. The firm has debt with a face value of $100. Why might stockholders prefer the high-risk project, even if its expected firm value is lower?

What is the term for the selfish investment strategy where a firm in financial distress pays out extra dividends, leaving less cash in the firm for bondholders?

Agreements in a loan's indenture that limit or prohibit actions a company might take, such as limiting dividend payments or asset sales, are known as what?

According to the static trade-off theory of capital structure, what is the optimal amount of debt for a firm?

What does the 'pie model' of the firm, when including real-world factors like taxes and bankruptcy costs, suggest that financial managers should try to maximize?

According to signaling theory, why would investors likely view a firm's announcement of a new debt issuance as a positive signal?

What is the primary implication of the free cash flow hypothesis for a firm's capital structure?

According to the pecking-order theory, what is the most preferred source of financing for a firm's new projects?

In a world with both corporate and personal taxes, a firm is indifferent between issuing debt and equity when the after-tax proceeds to investors are equal. Given a corporate tax rate (tC) and personal tax rates on bond interest (tB) and stock distributions (tS), which equation represents this point of indifference?

Which of the following firm characteristics is generally associated with a higher target debt-equity ratio, according to the factors discussed for establishing capital structure?

Day Corporation has cash flow prospects of either $100 or $50, each with a 50 percent probability. It has debt obligations of $60. If a recession occurs and cash flow is only $50, and there are $15 in bankruptcy costs, what is the total amount received by the bondholders?

The pecking-order theory suggests that firms prefer internal financing over external financing primarily to avoid what?

In the static trade-off model, the value of a levered firm is determined by the value of an unlevered firm plus the present value of the tax shield, minus what other component?

What is the primary reason that a purely financial merger, which reduces the combined firm's cash flow volatility, can be detrimental to stockholders?

Which of the following selfish investment strategies involves a firm forgoing a project with a positive NPV because most of the benefits would go to bondholders?

What is the primary argument from the 'free cash flow hypothesis' regarding managerial behavior?

Which statement best describes the difference in implications between the trade-off theory and the pecking-order theory regarding capital structure?

In a hypothetical scenario where the corporate tax rate is 35 percent, the personal tax rate on interest is 35 percent, and the personal tax rate on dividends is 15 percent, what are the after-tax proceeds to an investor from $1 of pre-tax corporate earnings if paid as a dividend versus if paid as interest?

What is meant by the agency cost of equity, as exemplified by the case of Ms. Pagell, the owner-entrepreneur?

According to empirical observations discussed in the chapter, which type of firm is most likely to have a high debt-to-equity ratio?

The case of a financially distressed firm choosing a high-risk project over a low-risk project, even when the high-risk project has a lower overall expected value, is an example of what?

What is a key reason that debt consolidation, such as having one or a few large lenders instead of many small ones, can reduce the costs of financial distress?

If investors perceive that a firm's stock is overvalued, what action are managers likely to take according to the pecking-order theory?

What is meant by the term 'financial slack' in the context of the pecking-order theory?

The integration of tax benefits and financial distress costs leads to the 'static trade-off' theory. How does the weighted average cost of capital (WACC) behave as a firm increases leverage from zero, according to this theory?

Studies of direct bankruptcy costs for large corporations, such as those by White, Altman, and Weiss, have generally found these costs to be what?

An agency cost of equity, such as a manager-owner taking excessive perquisites, is likely to be more pronounced in which scenario?

Which theory of capital structure best explains the observation that firms often accumulate large cash balances?

A firm is considering two financing plans. Under Plan I (all-equity), it will have 265,000 shares. Under Plan II, it will have 185,000 shares and $2.8 million in debt with a 10 percent interest rate. Ignoring taxes, what is the break-even level of EBIT where EPS is the same for both plans?

If a firm has a significant tax loss carryforward, making it unlikely to pay corporate taxes for many years, how does this affect its optimal capital structure decision according to the static trade-off theory?

The idea that firms with more tangible assets (like land and buildings) should have higher target debt ratios than firms with more intangible assets (like R and D) is based on what concept from the chapter?

What is the primary motive for managers to engage in a leveraged buyout (LBO) according to the chapter's discussion on agency costs?

Dream, Inc., has debt with a face value of $6 million. The market value of its stock is $13.3 million (350,000 shares at $38 per share). The value of the firm if it were all-equity would be $17.85 million. The corporate tax rate is 35 percent. What is the implied value of expected bankruptcy costs for the firm?

What is the primary shortcoming of using a firm's announced debt-to-equity ratio as a definitive signal of its value, according to the chapter's discussion of signaling theory?

If a corporation has the choice between paying out $1 of pre-tax earnings as interest to bondholders or as a dividend to stockholders, and the corporate tax rate is 40 percent, while personal tax rates on both interest and dividends are 20 percent, who receives more after-tax cash?

Which of the following is NOT listed as one of the three selfish investment strategies that stockholders of a distressed firm might pursue?

What is the key assumption that allows an increase in a firm's optimal debt level by discounting a future guaranteed after-tax inflow at the after-tax riskless interest rate?

A key implication of the pecking-order theory is that, all else equal, more profitable firms will likely have what kind of capital structure compared to less profitable firms?

Janetta Corp. has an EBIT of $975,000 per year in perpetuity. Its unlevered cost of equity is 14 percent and its corporate tax rate is 35 percent. The company has perpetual debt with a market value of $1.9 million. What is the total value of the company?

The conflict of interest that arises from the separation of ownership (stockholders) and control (managers) is the source of which type of cost discussed in the chapter?

How do rational bondholders typically protect themselves from the potential for stockholders to pursue selfish investment strategies when a firm is in financial distress?

What does the signaling theory of capital structure primarily rely on to be effective?

Which of the following would be an example of a positive covenant in a bond indenture?

If a company has a corporate tax rate of 35 percent and EBIT of $1 million, by how much does issuing $4 million of debt at 10 percent interest reduce its annual corporate tax payment?

Why are indirect costs of financial distress, such as lost sales or damaged supplier relationships, difficult to measure quantitatively?

What is the key insight of the 'pie model' of capital structure?

How does the extended static trade-off model incorporate the agency costs of equity?

In the context of capital structure, what is the 'coinsurance' effect?