Question

If a firm hits its capital structure optimal point and then continues to add debt, it would likely experience a. Record profits for the firm. b. Financial distress and bankruptcy. c. An attempted takeover by a corporate raider. d. A doubling of the balance sheet numbers. e. Increases in profit if the economy goes down.

14. Maintaining a level dividend (with slight increases) would NOT be important to a company using a. the homemade dividend policy b. the clientele dividend policy c. the residual dividend policy d. the compromise dividend policy e. the target dividend policy

15. All of the following are indirect bankruptcy costs EXCEPT one. Which one? a. Redirection of manager time from making money to handling the bankruptcy details. b. The opportunity cost of holding too much cash on the balance sheet. c. Loss of key employees due to general uncertainty. d. Having to forego positive NPV projects because of general uncertainty. e. Increased legal fees associated with the bankruptcy.

16. Cox Company has 20,000 shares of common stock at 89.00/share, 50,000 shares of preferred stock at 102.00/share and 5,000 bonds selling at 98. What are the weights the company should use in its WACC? a. common: 14%; preferred 78%; and debt 8% b. common: 8%; preferred: 47% and debt: 45% c. common: 15%; preferred: 6% and debt: 79% d. common: 8%; preferred: 45%; and debt 47% e. None of the above

Answer 1

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b. Financial distress and bankruptcy. This is because debt involves fixed periodic payments. This puts pressure on the firm's cash flows, as the debt service payments have to be made mandatorily.

(a) is incorrect. Higher-than-optimal debt does not result in higher profits

(c) is incorrect. There is no dilution of equity, hence there are less chances of a hostile takeover

(d) is incorrect. Higher debt does not double balance sheet figures.

(e) is incorrect. This is an incorrect conclusion