Answered: In a recession when income and wealth…

In a recession when income and wealth are falling, the demand for bonds a. rises; right Ob. falls; left O c. falls; right O d. rises; left and the demand curve shifts to the

Financial Management: Theory & Practice

16th Edition

ISBN:9781337909730

Author:Brigham

Publisher:Brigham

Chapter15: Capital Structure Decisions

Section: Chapter Questions

Problem 5MC: What happens to ROE for Firm U and Firm L if EBIT falls to $1,600? What happens if EBIT falls to...

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Question

In a recession when income and wealth are falling, the demand for bonds
a. rises; right
Ob. falls; left
O c. falls; right
O d. rises; left
and the demand curve shifts to the

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Periods in time that experience increasing price levels are known as periods of a. deflation b. recession c. inflation d. depression
During a period of economic expansion, when expected profitability is high, the demand curve for bonds shifts to the left.the supply curve of bonds shifts to the right.the equilibrium interest rate falls.the equilibrium price of bonds rises
Suppose you believe that the economy is just entering a recession. Your firm must raisecapital immediately, and debt will be used. Should you borrow on a long-term or a shorttermbasis? Why?
Suppose company Z is already in financial distress and the equity holders are very close to default. Suddenly there is a shock that causes an increase in the standard deviation of the return on company Z's assets. Which of the following correctly describes the new situation faced by company Z? A) Debt value will increase with the shock and equity holder are more likely to default. B) Equity value will increase with the shock and equity holder are less likely to default. C) Both Debt value and equity value will increase but the likelihood of default is unchanged. D) Both debt value and equity value will decrease and the likehood of default will increase.
Would the market-value debt ratio tend to be higher than the book-value debt ratioduring a stock market boom or a recession? Explain.
In the MM model, as the proportion of debt in the capital structure increases, the cost of equity a. increases. b. decreases. c. remains unchanged; there is no relationship between the two. d. initially rises rapidly, then increases slowly beyond some point.
Which of the following statements is false? A. Banks have high levels of liquidity assets and stable funding since the financial crisis. B. Compared with bonds with short-term duration, bonds with long-term duration have uncertainty regarding future creditworthiness. C. Expected loss can decrease with an increase in a bond’s recovery rate. D. Macaulay duration is calculated as modified duration divided by one plus the bond’s yield to maturity.
A fall in interest rates tends to push stock prices O and real estate prices up. and real estate prices down. O up and real estate prices down. down and real estate prices up.
Next, we need to calculate MMMs cost of debt. We can use different approaches to estimate it One approach is to take the companys interest expense and divide it by total debt (which is the sum of short-term debt and long-term debt). This approach only works if the historical cost of debt equals the yield to maturity in todays market (i.e., if MMMs outstanding bonds are trading at dose to par). This approach may produce misleading estimates in years in which MMM issues a significant amount of new debt. For example, if a company issues a great deal of debt at the end of the year, the full amount of debt will appear on the year-end balance sheet, yet we still may not see a sharp increase in annual interest expense because the debt was outstanding for only a small portion of the entire year. When this situation occurs, the estimated cost of debt will likely understate the true cost of debt. Another approach is to try to find this number in the notes to the companys annual report by accessing the company's home page and its Investor Relations section. Alternatively, you can go to other external sources, such as bondsonline.com, for corporate bond spreads, which can be used to find estimates of the cost of debt. Finally, you can also go to Morningstar.com, which will provide yield to maturity information on the firms various bond issues. A longer-term issues YTM could provide an estimate of the firms current cost of debt to be used in the WACC calculation. Remember that you need the after-tax cost of debt to calculate a firm's WACC, so you will need MMMs tax rate (which has averaged around 30% in recent years). What is your estimate of MMMs after-tax cost of debt?
What happens to ROE for Firm U and Firm L if EBIT falls to $1,600? What happens if EBIT falls to $1,200? What is the after-tax cost of debt? What does this imply about the impact of leverage on risk and return?
Is default risk premium likely to be pro-cyclical (i.e., increasing during economic expansion) or counter-cyclical (i.e., increasing during the economic recession)? Why?
Suppose you believe that the economy is just entering a recession. Your firm must raise capital immediately, and debt will be used. Should you borrow on a long-term or short-term basis? Why?