Question

To calculate the cost of debt for a firm, which of the following WOULD NOT be used?

a. The Present value

b. The number of years to maturity

c. The number of years since it was issued

d. The coupon payment amount

e. The Face value

Homemade leverage and homemade dividends

a. are ways for companies to compete in the areas of leverage and dividends

b. are ways of using personal borrowing, lending, and stock purchases to adjust exposure to policies.

c. Are ways for individuals to avoid taxes when they own stocks of highly leveraged companies.

d. are the same thing

e. None of the above.

When looking for the weighted average cost of capital, we are striving for the WACC that

a. minimizes the value of the firm

b. Balances the weights as evenly as possible between debt and equity.

c. Is the largest number.

d. maximizes the value of the firm.

e. Balances the rates on debt and equity as evenly as possible.

Financial distress costs

a. could result in bankruptcy of the firm

b. could be something like requiring payments COD.

c. are a possible result of too much debt

d. all of the above

e. None of the above

Answer 1

The cost of debt (r) is calculated from the equation

market value of debt = (Present value of coupon payments till maturity + present value of face value) discounted at the cost of debt

So, in all the calculations above, the numbers of years since debt was issued is not used.

Hence c) is the correct answer

As per MM theory, Homemade leverage and homemade dividends are ways for individuals to replicate the payoffs of similar firms which are using different capital structure and different dividend policies by borrowing, lending , selling etc

Hence b) is the correct answer

When looking for the weighted average cost of capital, the target is to minimise the WACC so that the value of the firm is maximised. Hence d) is the correct answer

Financial distress happens when a firm is in poor financial shape and may result in bankruptcy, higher cost of operations like customers not paying in advance and opting for COD etc. It is generally created by using more than required Debt. Hence d) is the correct answer