Principles of Corporate Finance (Mcgraw-hill/Irwin Series in Finance, Insurance, and Real Estate)
12th Edition
ISBN: 9781259144387
Author: Richard A Brealey, Stewart C Myers, Franklin Allen
Publisher: McGraw-Hill Education
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Chapter 18, Problem 26PS
Trade-off theory The trade-off theory relies on the threat of financial distress. But why should a public corporation ever have to land in financial distress? According to the theory, the firm should operate at the top of the curve in Figure 18.2. Of course market movements or business setbacks could bump it up to a higher debt ratio and put it on the declining, right-hand side of the curve. But in that case, why doesn’t the firm just issue equity, retire debt, and move back up to the optimal debt ratio? What are the reasons why companies don’t issue stock—or enough stock—quickly enough to avoid financial distress?
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Chapter 18 Solutions
Principles of Corporate Finance (Mcgraw-hill/Irwin Series in Finance, Insurance, and Real Estate)
Ch. 18 - Prob. 1PSCh. 18 - Tax shields Here are book and market value balance...Ch. 18 - Prob. 3PSCh. 18 - Tax shields The firm cant use interest tax shields...Ch. 18 - Financial distress This question tests your...Ch. 18 - Prob. 6PSCh. 18 - Prob. 7PSCh. 18 - Debt ratios Rajan and Zingales identified four...Ch. 18 - Prob. 9PSCh. 18 - Pecking-order theory Fill in the blanks: According...
Ch. 18 - Financial slack For what kinds of companies is...Ch. 18 - Tax shields Compute the present value of interest...Ch. 18 - Tax shields Suppose that Congress sets the top...Ch. 18 - Tax shields The trouble with MMs argument is that...Ch. 18 - Tax shields Look back at the Johnson Johnson...Ch. 18 - Agency costs Let us go back to Circular Files...Ch. 18 - Agency costs The Salad Oil Storage (SOS) Company...Ch. 18 - Prob. 20PSCh. 18 - Agency costs The possible payoffs from Ms....Ch. 18 - Leverage targets Some corporations debtequity...Ch. 18 - Prob. 25PSCh. 18 - Trade-off theory The trade-off theory relies on...
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- A firm is in a world with (a) taxes, (b) costs of financial distress, (c) agency conflicts between debt and equity holders, and (d) agency conflicts between managers and equity holders. Based on what we have discussed in class, which of these factors is most likely to hurt firm value if a firm decides to increase its leverage? a and b O all of them O a, b, and c c and d Ob and carrow_forwardA6) Finance Which one of the following statements is not correct? a) Market timing theory argues that companies issue equity when their P/E ratio is exceptionally high b) According to static trade-off theory agency costs of equity increase when CEO’s ownership of the firm is low c) Firm has no target capital structure if it follows the pecking order theory d) Home-made leverage is possible when no market imperfections existarrow_forwardWhich of the following statement is incorrect about the Peking Order Theory? A.Firms with high ratios of fixed assets tend to have higher debt ratio.The evidence exclusively supports the peking order theory B.When exernal finance is required,firms issue debt first and equity as a last resort C.Most profitable firms borrow less not because they have lower target debt but because they don't need external finance D.Firms prefer internal finance since funds can be raised without sending advers signalsarrow_forward
- TRUE OR FALSE Answer as either true or false and provide a reason for why. When a company pays dividends, its share price falls. Modigliani and Miller proposition II (without taxes) implies that the weighed average cost of capital increases as more debt is issued, since debt make the firm more risky The empirical findings that more profitable firms have lower debt ratios is consistent with the trade-off theory regarding capital structure. The WACC formula assumes that the amount of debt issued remains constant. Other things being equal, buying a put option is the same as selling a call optionarrow_forwardWhich of the following is a valid reason for a firm not to use as much debt as it can raise? Group of answer choices The use of more debt is expected to result in an increase in the firmʹs cost of capital when everything is considered More debt will increase the firmʹs riskiness All of them are valid reasons for a firm to use less debt than might be available The use of more debt is expected to result in a lower price/earnings ratioarrow_forwardFinancial slack is the amount of unused access to debt markets or bank financing. Which theory of capital structure would place the highest value on maintaining financial slack for a firm that is not in financial distress? Question 10 options: a) Trade-off theory b) Debt financing as a managerial constraint c) Pecking order theory d) Modigliani & Miller irrelevance theoryarrow_forward
- Which of the following about optimal capital structure is incorrect? Optimal capital structure is the mixed of debt and equity capital that minimizes the firm’s weighted average cost of capital A company that follows the pecking order theory will use external financing thru debt after exhausting all the possible financing thru equity The management empire-building theory views high interest payments as to prevent management from unreasonable spending A company can take advantage of its high corporate tax rate as tax shield, under the trade-off theoryarrow_forwardWhich of the following makes this a true statement? In this slightly more realistic world with corporate taxes, managers can: Multiple Choice maximize the firm's value by taking on as much equity as possible. maximize the firm's value by taking on as much debt as possible. minimize the firm's value by taking on as much debt as possible. maximize the firm's value by financing only with debt.arrow_forwardWhich of the following is incorrect about the Pecking Order Theory? A.Firms with high ratios of fixed assets to total assets tend to have higher debt ratios.This evidence exclusively supports the pecking order theory B.When external finance is required,firms issue debt first and equity as a last resort C.Most profitable firms borrow less not because they have lower target debt ratios but beause they don't need external finance D.Firms prefer internal finance since funds can be raised without sending adverse signalsarrow_forward
- Which of the following is/are true regarding payout policy to shareholders? A. Most of the time that firms announce an increase in dividends, the market reacts negatively, as this is an admission that the firm has few good investment opportunities going forward. B. Large, mature firms should return a lot of cash to shareholders because there aren’t enough good investment opportunities out there for them. C. Flexibility is one key reason why we have seen much more use of share repurchases to return cash to shareholders in the last 3 decades. D. The primary value driver for the firm is how cash is paid out, not cash generation. E. (A) and (B) F. (B) and (C) G. (C) and (D)arrow_forward7. The reason firms care about the amount of debt they use is because a. There are tax benefits to debt, so capital structure can affect the value of the firm b. Firms don't care about their amount of debt c. There are tax benefits of equity, so using debt can replace valuable equity d. None of the above 8. When an economy has a risk-free asset, all risk-averse investors should invest in either the risk-free asset or the highest Sharpe-ratio risky asset (or both) a. True b. False c. Too little information to tell d. None of the above 9. The CAPM equation (Security Market Line) is a useful tool when trying to identify a company's a. Weight Average Cost of Capital b. Required Return on Equity c. Expected Return on Equity d. All of the abovearrow_forwardWhich of the following is true regarding a company assuming more debt? Select one: a. Assuming more debt is always bad for the company b. Assuming more debt reduces leverage c. Assuming more debt can be good for the company as long as they earn a return in excess of the rate charged on the borrowed funds d. Assuming more debt is always good for the companyarrow_forward
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