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[4] The optimal capital structure has been achieved when the:
[A] weight of equity is equal to the weight of debt.
[B] debt-to-equity ratio selected results in the lowest possible weighted average cost of capital.
[C] cost of equity is maximized.

[5] The optimal capital structure will tend to include more debt for firms with:
[A] less taxable income.
[B] lower probability of financial distress.
[C] substantial tax shields from other sources.

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Beverley Smith
Beverley SmithLv2
28 Sep 2019
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An unlevered firm, Marshall Inc., has a constant EBIT of $1,500,000 per year in perpetuity. It is considering the use of some debt financing to repurchase shares. Based on the PV of bankruptcy costs of $2,500,000, the following schedule has been developed:

Value of Debt Probability of financial distress

$200,000 0.00%

600,000 1.00%

1,000,000 2.00%

2,000,000 7.00%

3,000,000 15.00%

4,000,000 40.00%

5,000,000 65.00%

The current cost of equity is 18%, and the tax rate is 40%. Assume that the company can borrow at a cost of 10%.

a) What is Marshall’s market value and the WACC before any debt is taken on?

b) In M&M’s case (world) II, what is Marshall’s optimal level of debt?

c) What is the optimal capital structure when financial distress costs are included?

d) Compute the WACC at the optimal capital structure determined in part (c).

An unlevered firm, Marshall Inc., has a constant EBIT of $1,500,000 per year in perpetuity. It is considering the use of some debt financing to repurchase shares. Based on the PV of bankruptcy costs of $2,500,000, the following schedule has been developed:

Value of Debt Probability of financial distress

$200,000 0.00%

600,000 1.00%

1,000,000 2.00%

2,000,000 7.00%

3,000,000 15.00%

4,000,000 40.00%

5,000,000 65.00%

The current cost of equity is 18%, and the tax rate is 40%. Assume that the company can borrow at a cost of 10%.

a) What is Marshall’s market value and the WACC before any debt is taken on?

b) In M&M’s case (world) II, what is Marshall’s optimal level of debt?

c) What is the optimal capital structure when financial distress costs are included?

d) Compute the WACC at the optimal capital structure determined in part (c).

[1] The explicit costs, such as the legal expenses, associated with corporate default are classified as _____ costs.
[A] beta conversion
[B] direct bankruptcy
[C] indirect bankruptcy

[2] An indirect cost of bankruptcy is the loss of key employees.
[A] True
[B] False

[3] A legal attempt to financially restructure a failing firm so that it can continue operating as a going concern is called a reorganization.
[A] True
[B] False

[4] The optimal capital structure has been achieved when the:
[A] weight of equity is equal to the weight of debt.
[B] debt-to-equity ratio selected results in the lowest possible weighted average cost of capital.
[C] cost of equity is maximized.

[5] The optimal capital structure will tend to include more debt for firms with:
[A] less taxable income.
[B] lower probability of financial distress.
[C] substantial tax shields from other sources.

[6] The optimal capital structure of a firm:
[A] will remain constant over time unless the firm makes an acquisition.
[B] will be the same for all firms in the same industry.
[C] will vary over time as taxes and market conditions change.

[7] In a world with corporate taxes, MM theory implies that that all firms should choose an all-debt capital structure.
[A] True
[B] False

[8] A firm is technically insolvent when:
[A] the value of its stock declines by more than 50 percent in any given 12-month period.
[B] the value of the firm's assets is less than the value of the firm's liabilities.
[C] it is unable to meet its financial obligations.

[9] Which one of the following statements is correct concerning a Chapter 7 bankruptcy?
[A] A firm reorganizes its operations in an effort to return to being a viable concern.
[B] A trustee will assume control of the firm's assets until those assets can be liquidated.

[10] If the net present value of a project is positive (non-zero), then the project's internal rate of return will exceed its required rate of return.
[A] True
[B] False

[11] Which one of these methods uses accounting values rather than financial values?
[A] AAR
[B] IRR
[C] NPV

[12] An investment should be accepted if the NPV is positive and rejected if it is negative.
[A] True
[B] False

[13] The length of time required for an investment to generate cash flows sufficient to recover the initial cost of the investment is called the:
[A] net present value.
[B] payback period.
[C] internal rate of return.

[14] An investment is acceptable if its average accounting return (AAR):
[A] exceeds the target AAR.
[B] is less than the target AAR.

[15] The discount rate that makes the net present value of an investment exactly equal to zero is called the internal rate of return.
[A] True
[B] False

[16] The most valuable investment given up if an alternative investment is chosen is referred to as a(n):
[A] sunk cost.
[B] opportunity cost.
[C] erosion cost.

[17] The cost of test marketing a product prior to deciding whether or not to produce the product is a sunk cost.
[A] True
[B] False

[18] An asset will be depreciated faster using MACRS rather than the straight-line method.
[A] True
[B] False

[19] The financial break-even point determines which one of these values?
[A] Fixed costs
[B] Variable cost per unit
[C] Sales quantity

[20] The return earned in an average year over a multi-year period is called the _____ average return.
[A] arithmetic
[B] standard
[C] geometric

[21] The capital gains yield plus the dividend yield on a security is called the:
[A] geometric return.
[B] total return.
[C] variance of returns.

[22] Which one of the following is an example of a nondiversifiable risk?
[A] A poorly managed firm suddenly goes out of business due to lack of sales
[B] A key employee of a firm suddenly resigns and accepts employment with a key competitor
[C] A well respected chairman of the Federal Reserve suddenly resigns

[23] Beta values are highly dependent on the covariance of a security with the market.
[A] True
[B] False

[24] Insider trading does not offer any advantages if the financial markets are:
[A] inefficient.
[B] semiweak form efficient.
[C] strong form efficient.

[25] MM Propositions ignore bankruptcy costs.
[A] True
[B] False

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