Chapter 18 FIN 303
Which of the following games do shareholders play when firms are in financial distress?
1. risk-shifting
Suppose that a firm that is all equity financed is valued at $300 million. The present value of its tax shield is $30 million. According to the principles of MM, what is the value of the firm?
300m + 30m = 330 Million
Suppose that a firm that is all equity financed is valued at $400 million. The present value of its tax shield is $30 million. According to the principles of MM, what is the value of the firm?
430 Million
The costs of financial distress depend mostly on how easily the ownership of the firm's ________ can be transferred.
Assets
Which costs of financial distress are easier to measure?
Direct Costs
True or false: According to M&M Proposition I, a firm's capital structure determines its value.
False
True or false: It is easy to measure indirect costs of financial distress.
False Reason: While the existence of indirect costs is recognized, these costs are not easy to measure.
Customers refusing to buy cars after GM filed for Chapter 11 (fearing the inability to service them in the future) is an example of ______ costs of financial distress.
Indirect
Which two of the following are broad types of costs of financial distress?
Indirect costs Direct costs
What is financial slack?
It is excess cash accumulated by the firm.
What is generally the most important component of direct costs in the case of bankruptcy?
Legal Costs
Stockholders of an unlimited liability firm lose __________ stockholders of a limited liability firm in bankruptcy.
More than
The costs of financial distress depend on which of the following:
Reason: The costs of financial distress depend on the probability of distress and the magnitude of costs if distress occurs
Which of the following is likely to be true when a bankruptcy ruling is issued?
The ownership of assets is transferred from the shareholders to the bondholders.
What do the academic studies conclude about the magnitude of direct costs of bankruptcy?
They are insignificant as a percentage of firm value.
Which of the following theories explains how much firms borrow?
Trade-off theory Pecking Order theory
True or false: In the case of a firm whose debt exceeds market value, a longer bond maturity means the firm has more time to try to generate profits to pay bondholders.
True
The relative tax advantage of debt when the corporate tax rate = 21%; and the personal tax rate on equity income = 20%; and the personal tax rate on interest income = 35% is _____________.
Very confused for this answer I think the key is wrong.
Which of the following games do shareholders play when firms are in financial distress?
cash in and run risk-shifting playing for time bait and switch
Financial distress occurs when promises to _________ are broken or honored with difficulty.
creditors
The value of a levered firm is higher than the value of an unlevered firm in the presence of corporate taxes owing to the tax shield benefit of:
debt
If a firm issues ______, shareholders will assume the firm's common stock is undervalued, but if a firm issues ______, shareholders will assume the firm's common stock is overvalued.
debt; equity
According to M&M Proposition I, a firm's capital structure choices:
do not affect the value of the firm
Stockholder of levered firms gain when business risk _________.
increases
According to the pecking order theory, where does a firm look to first for financing?
internal funds
Which of the following is the correct order of financing supporting the pecking order theory?
internal funds, new issues of debt, new issues of equity
Risk shifting occurs when a firm facing bankruptcy:
invests in high-risk, high-return projects
In practice, which of the following describes a firm with a high debt ratio?
large, mostly tangible assets, less profitable, lower market to book ratio
Bondholders protect themselves by placing which provisions in debt contracts?
limiting dividends restricting asset sales limiting more borrowing
What are some examples of indirect financial distress costs?
lost sales lost reputation
In practice, a firm with a low debt ratio will have which of the following characteristics?
low ratio of tangible to total assets highly profitable Reason: higher market to book ratio Reason: smaller in size
One of the indirect costs to bankruptcy is the incentive for shareholders turning down ___________ but positive NPV projects
low-risk, low-return
The costs of financial distress depend on which of the following:
magnitude of costs if distress occurs probability of distress
Under the trade-off theory, the optimal level of debt is reached when the marginal benefit of debt equals the marginal cost of debt. Under the pecking-order theory, debt is issued:
only after internal funds are exhausted
Financial slack helps firms avoid ___.
relying on external financing
One of the indirect costs to bankruptcy is the incentive for ___________ turning down low-risk, low-return but positive NPV projects
shareholders
Debt contracts protect bondholders against:
stockholders' interests other bondholders' interests
In the case of a firm whose debt exceeds market value, a longer bond maturity means that:
the firm has more time to try to generate profits to pay bondholders
One important benefit of debt financing for corporations is:
the interest it pays on debt is tax-deductible
The ____ theory is the dominant theory of capital structure.
trade-off
