FIN 302 CH 16 EXAM QUESTIONS WITH CORRECT ANSWERS LATEST UPDATE 2026

FIN 302 CH 16 EXAM QUESTIONS WITH CORRECT ANSWERS LATEST UPDATE 2026 Indirect costs of financial distress: A) Effectively limit the amount of equity a firm issues. B) Serve as an incentive to increase the financial leverage of a firm. C) Include costs such as legal and accounting fees. D) Tend to increase as the debt-equity ratio decreases. E) Include the costs incurred by a firm as it tries to avoid seeking bankruptcy protection. - Answers E The value of a firm is maximized when the: A) Cost of equity is maximized. B) Tax rate is zero. C) Levered cost of capital is maximized. D) Weighted average cost of capital is minimized. E) Debt-equity ratio is minimized. - Answers D The optimal capital structure has been achieved when the: A) Debt-equity ratio is equal to 1. B) Weight of equity is equal to the weight of debt. C) Cost of equity is maximized given a pretax cost of debt. D) Debt-equity ratio is such that the cost of debt exceeds the cost of equity. E) Debt-equity ratio selected results in the lowest possible weighed average cost of capital. - Answers E In a world with taxes and financial distress, when a firm is operating with the optimal capital structure the: A) Debt-equity ratio will be less than optimal. B) Weighted average cost of capital will be maximized. C) Firm will be all-equity financed. D) Required return on assets will be at its maximum point. E) Increased benefit from additional debt is equal to the increased bankruptcy costs of that debt. - Answers E The optimal capital structure of a firm _____ the marketable claims and _____ the non-marketable claims against the cash flows of the firm. A) Minimizes; minimizes B) Minimizes; maximizes C) Maximizes; minimizes D) Maximizes; maximizes E) Equates; (leave blank) - Answers C One of the indirect costs of bankruptcy is the incentive toward under-investment. Under investment generally would result in: A) The firm selecting all projects with positive NPVs. B) The firm turning down positive NPV projects that would clearly be accepted if the firm were all-equity financed. C) Bondholders contributing the full amount of any new investment, but both stockholders and bondholders sharing in the benefits of those investments. D) Shareholders making decisions based on the best interests of the bondholders. E) The firm accepting more projects than it would if the probability of bankruptcy was ignored. - Answers B If a firm issues debt and includes protective covenants in the indenture then the firm's debt will probably be issued at _____ similar debt without the covenants. A) A variable interest rate rather than the fixed rate paid on B) A lower interest rate than C) A significantly higher interest rate than D) An interest rate equal to that of E) A slightly higher interest rate than - Answers B A firm is currently valued at $300 in a boom and $160 otherwise. The chance of a boom is 35 percent. The firm owes $200 to its debt holders. What is the value of the firm to the shareholders? A) $0 B) $35.00 C) $27.50 D) $209.00 E) $9.00 - Answers B Shareholder value = .35 × MAX[($300 - 200),0] + (1 - .35) × MAX[($160 - 200),0] = $35 The optimal capital structure will tend to include more debt for firms with: A) The highest depreciation deductions. B) The lowest marginal tax rate. C) Substantial tax shields from other sources. D) Lower probability of financial distress. E) Less taxable income. - Answers D In general, the capital structures used by U.S. firms: A) Tend to overweight debt in relation to equity. B) Are easily explained in terms of earnings volatility. C) Are easily explained by analyzing the types of assets owned by the various firms. D) Tend to be those which maximize the use of the firm's available tax shelters. E) Vary significantly across industries. - Answers E The MM theory with taxes implies that firms should issue maximum debt. In practice, this does not occur because: A) Debt is more risky than equity. B) Bankruptcy is a disadvantage to debt. C) The weighted average cost of capital is inversely related to the debt-equity ratio. D) The weighted average cost of capital is directly related to the debt-equity ratio. E) U.S. regulations require the debt-equity ratio of publicly-traded firms to be in the range of .3 to .7. - Answers B One of the indirect costs of bankruptcy is the incentive for managers to take large risks. When following this strategy: A) The firm will rank all projects and select the project which results in the highest expected firm value. B) Bondholders expropriate value from stockholders by selecting high-risk projects. C) Stockholders expropriate value from bondholders by selecting high-risk projects. D) The firm will always select the lowest-risk project available. E) The firm will select only all-equity financed projects. - Answers C What's the difference between business risk and financial risk and what affects each of them? - Answers Business risk: The risk of whether or not a firm will be able to generate enough revenue from sales to cover its operating expenses and make a profit. Things that go into sales variability, like CFs, market conditions, industry conditions, COGS, profit margins, competition, overall demand for its products, whether the firm's assets are concrete, etc. Financial risk: Deals with leverage and debt financing, so it's whether or not a company can generate enough CFs to make interest payments. Interest rate changes and the weight of debt in the company's capital structure. Pecking order theory definition and rules - Answers Definition: The cost of financing increases with asymmetric info. Rules: 1. Use internal financing as much as possible 2. If outside financing is needed, debt should be issued before equity Implications of the pecking order theory - Answers 1. No target D/E ratio 2. Profitable firms use less debt 3. Companies like financial slack because they'll need to internally finance projects in the future Payoff to shareholders after restructuring - Answers -Capital gains + Dividends R0 - Answers Expected earnings to unlevered firm/Unlevered equity Tradeoff theory - Answers There's a tradeoff between the tax benefits of debt and the costs of financial distress What are the 3 selfish strategies? - Answers 1. Incentive to take large risks 2. Incentive toward underinvestment 3. Milking the property With corporate taxes and bankruptcy costs, the firm value is maximized where the ____________________________ from the _______________________ is _____________________ by the _______________ in ______________________________. - Answers Where the additional benefit from the interest tax shield is just offset by the increase in expected bankruptcy costs Butter & Jelly reduced its taxes last year by $350 by increasing its interest expense by $1,000. Which of the following terms is used to describe this tax savings? A. interest tax shield B. interest credit C. financing shield D. current tax yield E. tax-loss interest - Answers A. interest tax shield The unlevered cost of capital refers to the cost of capital for a(n): A. private entity. B. all-equity firm. C. governmental entity. D. private individual. E. corporate shareholder. - Answers B. all-equity firm The explicit costs, such as legal and administrative expenses, associated with corporate default are classified as _____ costs. A. flotation B. issue C. direct bankruptcy D. indirect bankruptcy E. unlevered - Answers C. direct bankruptcy The proposition that a firm borrows up to the point where the marginal benefit of the interest tax shield derived from increased debt is just equal to the marginal expense of the resulting increase in financial distress costs is called: A. the static theory of capital structure. B. M&M Proposition I. C. M&M Proposition II. D. the capital asset pricing model. E. the open markets theorem. - Answers A. the static theory of capital structure. Which one of the following is the legal proceeding under which an insolvent firm can be reorganized? A. restructure process B. bankruptcy C. forced merger D. legal takeover E. rights offer - Answers B. bankruptcy A business firm ceases to exist as a going concern as a result of which one of the following? A. divestiture B. share repurchase C. liquidation D. reorganization E. capital restructuring - Answers C. liquidation Edwards Farm Products was unable to meet its financial obligations and was forced into using legal proceedings to restructure itself so that it could continue as a viable business. The process this firm underwent is known as a: A. merger. B. repurchase program. C. liquidation. D. reorganization. E. divestiture. - Answers D. reorganization. A firm should select the capital structure that: A. produces the highest cost of capital. B. maximizes the value of the firm. C. minimizes taxes. D. is fully unlevered. E. equates the value of debt with the value of equity. - Answers B. maximizes the value of the firm. The optimal capital structure has been achieved when the: A. debt-equity ratio is equal to 1. B. weight of equity is equal to the weight of debt. C. cost of equity is maximized given a pre-tax cost of debt. D. debt-equity ratio is such that the cost of debt exceeds the cost of equity. E. debt-equity ratio results in the lowest possible weighted average cost of capital. - Answers E. debt-equity ratio results in the lowest possible weighted average cost of capital. M&M Proposition I with no tax supports the argument that: A. business risk determines the return on assets. B. the cost of equity rises as leverage rises. C. the debt-equity ratio of a firm is completely irrelevant. D. a firm should borrow money to the point where the tax benefit from debt is equal to the cost of the increased probability of financial distress. E. homemade leverage is irrelevant. - Answers C. the debt-equity ratio of a firm is completely irrelevant. M&M Proposition II is the proposition that: A. the capital structure of a firm has no effect on the firm's value. B. the cost of equity depends on the return on debt, the debt-equity ratio, and the tax rate. C. a firm's cost of equity is a linear function with a slope equal to (RA - RD). D. the cost of equity is equivalent to the required rate of return on a firm's assets. E. the size of the pie does not depend on how the pie is sliced. - Answers C. a firm's cost of equity is a linear function with a slope equal to (RA - RD).