Q: Which formula correctly calculates the present value of the interest tax shield for a perpetuity?

$$\frac{D \times r_D \times T_C}{r_D}$$

Question 1

According to Modigliani and Miller (MM) Proposition I in a tax-free economy, which of the following statements is correct regarding a firm's capital structure?

Accepted Answer

The market value of a company does not depend on its capital structure.

Question 2

A firm has an EBIT of $$158,228 and uses 500$$,000 of debt at a 10% interest rate. The corporate tax rate is 21%. What is the net cash flow to both equity and bondholders?

Accepted Answer

$135,500

Question 3

Which formula correctly calculates the present value of the interest tax shield for a perpetuity?

Accepted Answer

$$\frac{D 	imes r_D 	imes T_C}{r_D}$$

Question 4

If a company with no debt has annual cash flows of $10,000 before interest and taxes, and the corporate tax rate is 21%, what is the net cash flow to equity holders?

Accepted Answer

$7,900

Question 5

Which of the following best describes financial leverage?

Accepted Answer

The use of debt financing to amplify the effects of changes in operating income on the returns to stockholders.

Question 6

According to the Trade-off Theory, what determines a firm's optimal debt level?

Accepted Answer

Balancing the interest tax shields against the costs of financial distress.

Question 7

A company issues $50,000 in 6% bonds. The corporate tax rate is 21%. What is the annual tax benefit from the interest tax shield?

Accepted Answer

$630

Question 8

Which of the following is a cost of financial distress?

Accepted Answer

Distorted business decisions made before bankruptcy.

Question 9

In the context of capital structure, what is 'debt overhang'?

Accepted Answer

When firms threatened with default may pass up positive-NPV projects because bondholders capture part of the value added.

Question 10

Which industry has the highest average book debt ratio according to the provided data?

Accepted Answer

Telecoms

Question 11

If a firm increases its proportion of debt in the capital structure, what happens to the expected return on equity according to MM’s Proposition II (with fixed interest rate)?

Accepted Answer

It increases.

Question 12

Which of the following is NOT an assumption of the Modigliani and Miller (MM) Proposition I in a tax-free economy?

Accepted Answer

There are bankruptcy costs.

Question 13

A firm has $500,000 in debt at 10% interest and a corporate tax rate of 21%. What is the present value of the tax shield if the debt is perpetual?

Accepted Answer

$105,000

Question 14

Which theory states that firms prefer internal financing to issuing debt, and prefer issuing debt rather than equity?

Accepted Answer

Pecking Order Theory

Question 15

What is the formula for the debt to total capital ratio?

Accepted Answer

$$\frac{D}{D+E}$$

Question 16

Which of the following best describes a loan covenant?

Accepted Answer

An agreement between firm and lender requiring the firm to fulfill certain conditions to safeguard the loan.

Question 17

If a firm is threatened with default and shifts to riskier investments, which financing game is being played?

Accepted Answer

Risk shifting

Question 18

Which of the following is NOT a component of the market value of a firm in the presence of taxes and financial distress?

Accepted Answer

PV of operating risk

Question 19

A company with $50,000 in perpetual debt at 6% interest and a 21% tax rate has a present value of the tax shield of:

Accepted Answer

$10,500

Question 20

Which of the following best describes financial slack?

Accepted Answer

Ready access to cash or debt financing.

Capital Structure, Debt, and Value: Financial Accounting Study Notes

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