Financial Management Exam 2

Which of the following is NOT one of Modigliani and​ Miller's set of conditions referred to as perfect capital​ markets? Question content area bottom Part 1 A. All investors hold an efficient portfolio of assets. B. There are no​ taxes, transaction​ costs, or issuance costs associated with security trading. C. Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows. D. A​ firm's financing decisions do not change the cash flows generated by its​ investments, nor do they reveal new information about them.

A. All investors hold an efficient portfolio of assets.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. As Modigliani and Miller made clear in their original​ work, capital structure matters in perfect capital markets.​ Thus, if capital structure does not​ matter, then it must stem from a market imperfection. B. The interest tax shield is the additional amount that a firm would have paid in taxes if it did not have leverage. C. Because corporations pay taxes on their profits after interest payments are​ deducted, interest expenses reduce the amount of corporate tax firms must pay. D. In​ general, the gain to investors from the tax deductibility of interest payments is referred to as the interest tax shield.

A. As Modigliani and Miller made clear in their original​ work, capital structure matters in perfect capital markets.​ Thus, if capital structure does not​ matter, then it must stem from a market imperfection.

Which of the following statements regarding the adjusted present value method is​ FALSE? Question content area bottom Part 1 A. A​ firm's levered cost of capital is a weighted average of its equity and debt costs of capital. B. The​ firm's unlevered cost of capital is equal to its pre−tax weighted average cost of capital—that ​is, using the pre−tax cost of​ debt, rd​, rather than its after−tax ​cost, rd​ (1 − τc​ ). C. When the firm maintains a target leverage​ ratio, its future interest tax shields have similar risk to the​ project's cash​ flows, so they should be discounted at the​ project's unlevered cost of capital. D. The first step in the APV method is to calculate the value of free cash flows using the​ project's cost of capital if it were financed without leverage.

A. A​ firm's levered cost of capital is a weighted average of its equity and debt costs of capital.

Which of the following is NOT an indirect cost of​ bankruptcy? Question content area bottom Part 1 A. Costs of appraisers B. Fire sales of assets C. Loss of employees D. Loss of suppliers

A. Costs of appraisers

Which of the following is NOT a direct cost of​ bankruptcy? Question content area bottom Part 1 A. Costs to creditors B. Legal costs and fees C. Investment banking costs D. Costs of accounting experts

A. Costs to creditors

Which of the following is NOT a step in the valuation process using the flow to equity​ method? Question content area bottom Part 1 A. Determine the before−tax cost of​ capital, rU. B. Compute the equity​ value, E​, by discounting the free cash flow to equity using the equity cost of capital. C. Determine the free cash flow to equity of the investment. D. Determine the equity cost of​ capital, rE.

A. Determine the before−tax cost of​ capital, rU.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. Equity investors must pay taxes on dividends but not capital gains. B. The value of a firm is equal to the amount of money the firm can raise by issuing securities. C. By reducing a​ firm's corporate tax​ liability, debt allows the firm to pay more of its cash flows to investors. D. For​ individuals, interest payments received from debt are taxed as income.

A. Equity investors must pay taxes on dividends but not capital gains.

For the same increase in interest​ expense, how will free cash flow​ change? ​(Select the best choice​ below.) A. Free cash flow is not affected by interest expense. B. Free cash flow decreases by the amount of the interest expense. C. Free cash flow increases by the amount of the interest expense. D. None of the above.

A. Free cash flow is not affected by interest expense.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. Modigliani and​ Miller's conclusion verified the common​ view, which stated that even with perfect capital​ markets, leverage would affect a​ firm's value. B. Investors in levered equity require a higher expected return to compensate for its increased risk. C. Leverage increases the risk of equity even when there is no risk that the firm will default. D. We can evaluate the relationship between risk and return more formally by computing the sensitivity of each​ security's return to the systematic risk of the economy.

A. Modigliani and​ Miller's conclusion verified the common​ view, which stated that even with perfect capital​ markets, leverage would affect a​ firm's value.

How can too much debt lead to excessive​ risk-taking? Part 2 ​(Select the best choice​ below.) A. Shareholders capture upside​ benefits, but​ don't suffer from downside losses. B. Risky projects become attractive to debt holders. C. Debt covenants encourage excessive risk taking by equity holders. D. None of the answers represents a reason why too much debt can lead to excessive risk taking.

A. Shareholders capture upside​ benefits, but​ don't suffer from downside losses.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. The costs of financial distress reduce the value of the levered​ firm, VL. The amount of the reduction decreases with the probability of​ default, which in turn increases with the level of the debt D. B. Firms with​ steady, reliable cash​ flows, such as utility​ companies, are able to use high levels of debt and still have a very low probability of default. C. If there were no costs of financial​ distress, the value of the firm would continue to increase with increasing debt until the interest on the debt exceeds the​ firm's earnings before interest and taxes and the tax shield is exhausted. D. The tradeoff theory states that firms should increase their leverage until it reaches the level D​* for which VL is maximized.

A. The costs of financial distress reduce the value of the levered​ firm, VL. The amount of the reduction decreases with the probability of​ default, which in turn increases with the level of the debt D.

n a world with corporate​ taxes, but no other market​ frictions, how does increasing leverage affect firm value and​ WACC? Part 2 ​(Select the best choice​ below.) A. WACC​ decreases, and value increases. B. WACC and value are unaffected. C. WACC​ increases, and value decreases. D. WACC and value increase.

A. WACC​ decreases, and value increases.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. When a firm changes its capital structure without changing its​ investments, its levered beta will remain​ unaltered, however, its asset beta will change to reflect the effect of the capital structure change on its risk. B. If a firm holds​ $1 in cash and has​ $1 of risk−free ​debt, then the interest earned on the cash will equal the interest paid on the debt. The cash flows from each source cancel each​ other, just as if the firm held no cash and no debt. C. The unlevered beta measures the market risk of the firm without​ leverage, which is equivalent to the beta of the​ firm's assets. D. The unlevered beta measures the market risk of the​ firm's business​ activities, ignoring any additional risk due to leverage.

A. When a firm changes its capital structure without changing its​ investments, its levered beta will remain​ unaltered, however, its asset beta will change to reflect the effect of the capital structure change on its risk.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. When securities are fairly​ priced, the original shareholders of a firm pay the future value of the costs associated with bankruptcy and financial distress. B. Levered firms risk incurring financial distress costs that reduce the cash flows available to investors. C. Debt holders are not foolish—they recognize that when the firm​ defaults, they will not be able to get the full value of the assets. As a​ result, they will pay less for the debt initially. D. The costs of financial distress represent an important departure from Modigliani and​ Miller's assumption of perfect capital markets.

A. When securities are fairly​ priced, the original shareholders of a firm pay the future value of the costs associated with bankruptcy and financial distress.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. When we relax the assumption of a constant debt−equity ​ratio, the APV and FTE methods are difficult to implement. B. If a firm is using leverage to shield income from corporate​ taxes, then it will adjust its debt level so that its interest expenses grow with its earnings. C. When we relax the assumption of a constant debt−equity ​ratio, the equity cost of capital and WACC for a project will change over time as the debt−equity ratio changes. D. Rather than set debt according to a target debt−equity ratio or interest coverage​ level, a firm may adjust its debt according to a fixed schedule that is known in advance.

A. When we relax the assumption of a constant debt−equity ​ratio, the APV and FTE methods are difficult to implement.

Which of the following statements is​ FALSE? A. While ownership is often diluted for​ small, young​ firms, ownership typically becomes concentrated over time as a firm grows. B. While overspending on personal perks may be a problem for large​ firms, these costs are likely to be small relative to the overall value of the firm. C. A serious concern for large corporations is that managers may make​ large, unprofitable investments. D. Some financial economists explain a​ manager's willingness to engage in negative−NPV investments as empire building.

A. While ownership is often diluted for​ small, young​ firms, ownership typically becomes concentrated over time as a firm grows.

Equity in a firm with debt is​ called: Question content area bottom Part 1 A. levered equity. B. risky equity. C. unlevered equity. D. riskless equity.

A. levered equity.

The idea that managers who perceive the​ firm's equity is underpriced will have a preference to fund investment using retained​ earnings, or​ debt, rather than equity is known as​ the: A. pecking order hypothesis. B. credibility principle. C. signaling theory of debt. D. lemons principle.

A. pecking order hypothesis.

The assumption that the​ firm's debt−equity ratio is constant​ means: Question content area bottom Part 1 A. the​ firm's cost of capital will not fluctuate when it accepts a new project. B. the risk of its debt and equity will change when it accepts a new project. C. the firm adjusts its leverage to maintain a constant debt−equity ratio in terms of book value. D. corporate taxes are the only imperfection.

A. the​ firm's cost of capital will not fluctuate when it accepts a new project.

Which of the following is not the assumption for the 3 main methods in capital structure? A. Company pays all out earnings as dividends B. Project has average risk C. Firms DE ratio is constant D. Corporate taxes are the only imperfect

A. Company pays all out earnings as dividends

Which of the following factors should Cisco consider when making a financing​ decision? Part 2 ​(Select the best choice​ below.) A. Its tax rate. B. The volatility of the its cash flows. C. The magnitude of business disruption costs if it were to face financial distress. D. All answers are correct.

All answers correct

Which of the following is part of a​ firm's capital​ structure? Part 2 ​(Select the best choice​ below.) A. Debt B. Preferred Stock C. Equity D. All answers are correct.

All answers correct

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. While developing a Chapter 11 reorganization​ plan, management continues to operate the business. B. According to the provisions of the 1978 Bankruptcy Reform​ Act, U.S. firms can file for two forms of bankruptcy​ protection: Chapter 11 or Chapter 13. C. In the more common form of bankruptcy for large​ corporations, Chapter 11​ reorganization, all pending collection attempts are automatically​ suspended, and the​ firm's existing management is given the opportunity to propose a reorganization plan. D. The Chapter 11 reorganization plan specifies the treatment of each creditor of the firm. In addition to cash​ payment, creditors may receive new debt or equity securities of the firm. The value of cash and securities is generally less than the amount each creditor is​ owed, but more than the creditors would receive if the firm were shut down immediately and liquidated.

B. According to the provisions of the 1978 Bankruptcy Reform​ Act, U.S. firms can file for two forms of bankruptcy​ protection: Chapter 11 or Chapter 13.

Which of the following is NOT a step in the WACC valuation​ method? Question content area bottom Part 1 A. Compute the weighted average cost of capital. B. Adjust the WACC for the​ firm's current​ debt/equity ratio. C. Compute the value of the​ investment, including the tax benefit of​ leverage, by discounting the free cash flow of the investment using the WACC. D. Determine the free cash flow of the investment.

B. Adjust the WACC for the​ firm's current​ debt/equity ratio.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. The total market value of the​ firm's securities is equal to the market value of its​ assets, whether the firm is unlevered or levered. B. Although debt does not have a lower cost of capital than​ equity, we can consider this cost in isolation. C. While debt itself may be​ cheap, it increases the risk and therefore the cost of capital of the​ firm's equity. D. We can use Modigliani and​ Miller's first proposition to derive an explicit relationship between leverage and the equity cost of capital.

B. Although debt does not have a lower cost of capital than​ equity, we can consider this cost in isolation.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. If securities are fairly​ priced, then buying or selling securities has an NPV of zero​ and, therefore, should not change the value of a firm. B. An investor who would like more leverage than the firm has chosen can lend and add leverage to his or her own portfolio. C. The future repayments that the firm must make on its debt are equal in value to the amount of the loan it receives up front. D. As long as the​ firm's choice of securities does not change the cash flows generated by its​ assets, the capital structure decision will not change the total value of the firm or the amount of capital it can raise.

B. An investor who would like more leverage than the firm has chosen can lend and add leverage to his or her own portfolio.

Which of the following statements is​ FALSE? A. The optimal level of debt D​* balances the costs and benefits of leverage. B. As the debt level​ increases, the firm faces decreased incentives for​ management, which increase wasteful investment and perks. C. As the debt level​ increases, the firm benefits from the interest tax shield​ (which has present value τ​*D​). D. If the debt level is too​ large, firm value is reduced due to the loss of tax benefits​ (when interest exceeds​ EBIT), financial distress​ costs, and the agency costs of leverage.

B. As the debt level​ increases, the firm faces decreased incentives for​ management, which increase wasteful investment and perks.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. Technology firms are likely to incur high costs when they are in financial​ distress, due to the potential for loss of customers and key​ personnel, as well as a lack of tangible assets that can be easily liquidated. B. Calculating the precise present value of financial distress costs is a relatively straightforward process. C. The magnitude of the financial distress costs will depend on the relative importance of the sources of these costs and is likely to vary by industry. D. Two key qualitative factors determine the present value of financial distress​ costs: (1) the probability of financial distress and​ (2) the magnitude of the costs after a firm is in distress.

B. Calculating the precise present value of financial distress costs is a relatively straightforward process.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. A firm that fails to make the required interest or principal payments on the debt is in default. B. Equity holders expect to receive dividends and the firm is legally obligated to pay them. C. In the extreme​ case, the debt holders take legal ownership of the​ firm's assets through a process called bankruptcy. D. After a firm​ defaults, debt holders are given certain rights to the assets of the firm.

B. Equity holders expect to receive dividends and the firm is legally obligated to pay them.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. When evaluating any potential investment​ project, we must use a discount rate that is appropriate given the risk of the​ project's free cash flow. B. If we can identify a comparison firm whose assets have the same risk as the project being​ evaluated, and if the comparison firm is​ levered, then we can use its equity cost of capital as the cost of capital for the project. C. The portfolio of a​ firm's equity and debt replicates the returns we would earn if the firm were unlevered. D. We can calculate the cost of capital of the​ firm's assets by computing the weighted average of the​ firm's equity and debt cost of​ capital, which we refer to as the​ firm's weighted average cost of capital​ (WACC).

B. If we can identify a comparison firm whose assets have the same risk as the project being​ evaluated, and if the comparison firm is​ levered, then we can use its equity cost of capital as the cost of capital for the project.

Which of the following questions is​ FALSE? Question content area bottom Part 1 A. If the financing of the project involves an equity​ issue, and if management believes that the equity will sell at a price that is less than its true​ value, this mispricing is a cost of the project for the existing shareholders. B. Sometimes management may believe that the securities they are issuing are priced at less than​ (or more​ than) their true value. If​ so, the NPV of the​ transaction, which is the difference between the actual money raised and the true value of the securities​ sold, should not be included in the value of the project. C. An alternative method of incorporating financial distress and agency costs is to first value the project ignoring these​ costs, and then value the incremental cash flows associated with financial distress and agency problems separately. D. When the debt level—​and, ​therefore, the probability of financial distress—is ​high, the expected free cash flow will be reduced by the expected costs associated with financial distress and agency problems.

B. Sometimes management may believe that the securities they are issuing are priced at less than​ (or more​ than) their true value. If​ so, the NPV of the​ transaction, which is the difference between the actual money raised and the true value of the securities​ sold, should not be included in the value of the project.

Why would managers of Cisco choose a different capital structure than those in a different​ industry? Part 2 ​(Select the best choice​ below.) A. The level of managerial risk aversion varies across industries. B. The costs and benefits of debt vary across firms and industries. C. Banks are more willing to loan money to firms in certain industries than in others. D. Industries have different norms for which they need to comply.

B. The costs and benefits of debt vary across firms and industries.

Which of the following statements regarding recapitalizations is​ FALSE? Question content area bottom Part 1 A. Leveraged recaps were especially popular in the mid− to late−​1980s, when many firms found that these transactions could reduce their tax payments. B. The share price always rises after the completion of the recapitalization. C. When a firm makes a significant change to its capital​ structure, the transaction is called a recapitalization. D. With a​ recapitalization, even though leverage reduces the total value of​ equity, shareholders capture the benefits of the interest tax shield up front.

B. The share price always rises after the completion of the recapitalization.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. Holding fixed the cash flows generated by the​ firm's assets,​ however, the choice of capital structure does not change the value of the firm. B. When a firm issues new shares that account for a significant percentage of its outstanding​ shares, the transaction is called a leveraged recapitalization. C. MM Proposition I applies to capital structure decisions made at any time during the life of the firm. D. By choosing positive−NPV ​projects, the firm can enhance its value.

B. When a firm issues new shares that account for a significant percentage of its outstanding​ shares, the transaction is called a leveraged recapitalization.

Question content area top Part 1 A type of agency problem that results in shareholders gaining from decisions that increase the risk of the firm​ sufficiently, even if they have negative NPV​ is: Question content area bottom Part 1 A. underinvestment. B. asset substitution. C. cashing out. D. debt overhang.

B. asset substitution.

Question content area top Part 1 A type of agency problem that results in shareholders gaining by choosing not to finance​ new, positive−NPV projects​ is: Question content area bottom Part 1 A. excessive risk−taking. B. debt overhang. C. distress costs. D. asset substitution.

B. debt overhang.

Part 1 The term moral hazard refers​ to: A. the chance the firm will default and impose losses on its debt holders. B. the idea that individuals will change their behavior if they are not fully exposed to its consequences. C. the over−investment problem. D. the under−investment problem.

B. the idea that individuals will change their behavior if they are not fully exposed to its consequences.

If you ignore the possibility of a government​ bailout, the decision to pay a dividend given how close the company was to financial distress is an example of what kind of​ cost? ​(Select the best choice​ below.) A. Asset substitution B. Debt overhang C. Cashing out D. Over investment

C. Cashing out

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. With tangible​ assets, the financial distress costs of leverage are likely to be​ low, as the assets can be liquidated for close to their full value. B. Proponents of the management entrenchment theory of capital structure believe that managers choose a capital structure to avoid the discipline of debt and maintain their own job security. C. Firms with high​ R&D costs and future growth opportunities typically maintain high debt levels. D. The tradeoff theory explains how firms should choose their capital structures to maximize value to current shareholders.

C. Firms with high​ R&D costs and future growth opportunities typically maintain high debt levels.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. When securities are fairly​ priced, the original shareholders of a firm capture the full benefit of the interest tax shield from an increase in leverage. B. We can analyze the recapitalization using the market value balance​ sheet; it states that the total market value of a​ firm's securities must equal the total market value of the​ firm's assets. C. In the presence of corporate​ taxes, we do not include the interest tax shield as one of the​ firm's assets on its market value balance sheet. D. Once investors know the recap will​ occur, the share price will rise immediately to a level that reflects the value of the interest tax shield that the firm will receive from its recapitalization.

C. In the presence of corporate​ taxes, we do not include the interest tax shield as one of the​ firm's assets on its market value balance sheet.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. We can estimate rU for a new project by looking at single−division firms that have similar business risks. B. Projects may vary in the amount of leverage they will support—for ​example, acquisitions of real estate or capital equipment are often highly​ levered, whereas investments in intellectual property are not. C. In the real​ world, specific projects should differ only slightly from the average investment made by the firm. D. The​ project's equity cost of capital depends on its unlevered cost of​ capital, rU​, and the debt−equity ratio of the incremental financing that will be put in place to support the project.

C. In the real​ world, specific projects should differ only slightly from the average investment made by the firm.

Which of the following is NOT an indirect cost of​ bankruptcy? Question content area bottom Part 1 A. Delayed liquidation B. Costs to creditors C. Legal fees D. Loss of customers

C. Legal fees

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. In a perfect capital​ market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure. B. With perfect capital​ markets, leverage merely changes the allocation of cash flows between debt and​ equity, without altering the total cash flows of the firm. C. The Law of One Price implies that leverage will affect the total value of the firm under perfect capital market conditions. D. In the absence of taxes or other transaction​ costs, the total cash flow paid out to all of a​ firm's security holders is equal to the total cash flow generated by the​ firm's assets.

C. The Law of One Price implies that leverage will affect the total value of the firm under perfect capital market conditions.

Which of the following questions is​ FALSE? Question content area bottom Part 1 A. With perfect capital​ markets, all securities are fairly priced and issuing securities is a zero−NPV transaction. B. The​ WACC, APV, and FTE methods determine the value of an investment incorporating the tax shields associated with leverage. C. The fees associated with the financing of a project are independent of the​ project's required cash flows and should be ignored when calculating the NPV of the project. D. When a firm borrows​ funds, a mispricing scenario arises if the interest rate charged differs from the rate that is appropriate given the actual risk of the loan.

C. The fees associated with the financing of a project are independent of the​ project's required cash flows and should be ignored when calculating the NPV of the project.

Assume Cisco increases its leverage. How does this affect the risk its equity holders face and its cost of​ equity? Part 2 ​(Select the best choice​ below.) A. If markets are​ frictionless, then​ Cisco's cost of equity is unaffected by leverage. B. The risk faced by​ Cisco's equity holders and its cost of equity fall with leverage. C. The risk faced by​ Cisco's equity holders and its cost of equity rise with leverage. D. The risk faced by​ Cisco's equity holders rises and its cost of equity falls with leverage.

C. The risk faced by​ Cisco's equity holders and its cost of equity rise with leverage.

Assume capital markets are perfect. In what way does a​ firm's value​ and/or WACC change by relying more on debt​ capital? Part 2 ​(Select the best choice​ below.) A. WACC​ decreases, and value increases. B. WACC increases and value decreases. C. WACC and value are unaffected. D. WACC and value increase.

C. WACC and value are unaffected.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. Agency costs are costs that arise when there are conflicts of interest between stakeholders. B. When a firm has​ leverage, a conflict of interest exists if investment decisions have different consequences for the value of equity and the value of debt. C. When a firm faces financial​ distress, creditors can gain by making sufficiently risky​ investments, even if they have negative NPV. D. In some​ circumstances, managers may take actions that benefit shareholders but harm the​ firm's creditors and lower the total value of the firm.

C. When a firm faces financial​ distress, creditors can gain by making sufficiently risky​ investments, even if they have negative NPV.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. With a constant interest coverage​ policy, the value of the interest tax shield is proportional to the​ project's unlevered value. B. When the firm keeps its interest payments to a target fraction of its​ FCF, we say it has a constant interest coverage ratio. C. When we relax the assumption of a constant debt−equity ​ratio, the FTE method is relatively straightforward to use and is therefore the preferred method with alternative leverage policies. D. When debt levels are set according to a fixed​ schedule, we can discount the predetermined interest tax shields using the debt cost of​ capital, rD.

C. When we relax the assumption of a constant debt−equity ​ratio, the FTE method is relatively straightforward to use and is therefore the preferred method with alternative leverage policies.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. With no​ debt, the WACC is equal to the unlevered equity cost of capital. B. As the firm borrows at the low cost of capital for​ debt, its equity cost of capital​ rises, but the net effect is that the​ firm's WACC is unchanged. C. With perfect capital​ markets, a​ firm's WACC is dependent on its capital structure and is equal to its equity cost of capital only if the firm is levered. D. Although debt has a lower cost of capital than​ equity, leverage does not lower a​ firm's WACC.

C. With perfect capital​ markets, a​ firm's WACC is dependent on its capital structure and is equal to its equity cost of capital only if the firm is levered.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. To be​ profitable, a project should generate an expected return of at least the​ firm's weighted average cost of capital. B. The WACC can be used throughout the firm as the company wide cost of capital for new investments that are of comparable risk to the rest of the firm and that will not alter the​ firm's debt−equity ratio. C. The intuition for the WACC method is that the​ firm's weighted average cost of capital represents the average return the firm must pay to its investors​ (both debt and equity​ holders) on an after−tax basis. D. A disadvantage of the WACC method is that you need to know how the​ firm's leverage policy is implemented to make the capital budgeting decision.

D. A disadvantage of the WACC method is that you need to know how the​ firm's leverage policy is implemented to make the capital budgeting decision.

Question content area top Part 1 Which of the following statements is​ FALSE? Question content area bottom Part 1 A. Covenants are often designed to prevent management from exploiting debt​ holders, so they may help to reduce agency costs. B. Creditors often place restrictions on the actions that the firm can take. Such restrictions are referred to as debt covenants. C. Covenants may limit the​ firm's ability to pay large dividends or the types of investments that the firm can make. D. Agency costs are smallest for long−term debt.

D. Agency costs are smallest for long−term debt.

Which of the following methods are used in capital budgeting​ decisions? Question content area bottom Part 1 A. Adjusted present value​ (APV) method B. Flow−to−equity ​(FTE) method C. Weighted average cost of capital​ (WACC) method D. All of the above are used in capital budgeting decisions.

D. All of the above are used in capital budgeting decisions.

Which of the following influences a​ firm's choice of capital​ structure? A. Signaling and adverse selection B. Agency costs and benefits of leverage C. Taxes D. All of the above influence capital structure decisions.

D. All of the above influence capital structure decisions.

Which of the following firms is likely to maintain low levels of​ debt? A. A tobacco company B. A mature restaurant chain C. An electric utility D. An Internet firm

D. An Internet firm

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. Because the assets of the firm might be more valuable if kept​ together, creditors seizing assets in a piecemeal fashion might destroy much of the remaining value of the firm. B. Debt holders can then take legal action against the firm to collect payment by seizing the​ firm's assets. C. The U.S. bankruptcy code was created to organize this process so that creditors are treated fairly and the value of the assets is not needlessly destroyed. D. Because most firms have multiple​ creditors, coordination makes it difficult to guarantee that each creditor will be treated fairly.

D. Because most firms have multiple​ creditors, coordination makes it difficult to guarantee that each creditor will be treated fairly.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. Holding cash has the opposite effect of leverage on risk and return. B. We use the market value of the​ firm's net debt when computing its WACC and unlevered beta to measure the cost of capital and market risk of the​ firm's business assets. C. Since the WACC does not change with the use of​ leverage, the value of the​ firm's free cash flow evaluated using the WACC does not​ change, and so the enterprise value of the firm does not depend on its financing choices. D. Even if the​ firm's capital structure is more​ complex, the WACC is calculated by computing the weighted average cost of only the​ firm's debt and equity.

D. Even if the​ firm's capital structure is more​ complex, the WACC is calculated by computing the weighted average cost of only the​ firm's debt and equity.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. As a general​ rule, the WACC method is the easiest to use when the firm will maintain a fixed debt−to−value ratio over the life of the investment. B. The FTE method is typically used only in complicated settings for which the values of other securities in the​ firm's capital structure or the interest tax shield are themselves difficult to determine. C. When used​ consistently, the​ WACC, APV, and FTE methods produce the same valuation for the investment. D. For alternative leverage​ policies, the FTE method is usually the most straightforward approach.

D. For alternative leverage​ policies, the FTE method is usually the most straightforward approach.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. Because the cash flows of the debt and equity sum to the cash flows of the​ project, by the Law of One Price the combined values of debt and equity must be equal to the cash flows of the project. B. It is inappropriate to discount the cash flows of levered equity at the same discount rate that we use for unlevered equity. C. Franco Modigliani and Merton Miller argued that with perfect capital​ markets, the total value of a firm should not depend on its capital structure. D. Leverage decreases the risk of the equity of a firm.

D. Leverage decreases the risk of the equity of a firm.

Which of the following statements is​ FALSE? A. The separation of ownership and control creates the possibility of management​ entrenchment; facing little threat of being fired and​ replaced, managers are free to run the firm in their own best interests. B. The costs of reduced effort and excessive spending on perks are another form of agency cost. C. Managers also have their own personal​ interests, which may differ from those of both equity holders and debt holders. D. One disadvantage of using leverage is that it does not allow the original owners of the firm to maintain their equity stake.

D. One disadvantage of using leverage is that it does not allow the original owners of the firm to maintain their equity stake.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. When the market risk of the project is similar to the average market risk of the​ firm's investments, then its cost of capital is equivalent to the cost of capital for a portfolio of all of the​ firm's securities; that​ is, the​ project's cost of capital is equal to the​ firm's weighted average cost of capital​ (WACC). B. Because the WACC incorporates the tax savings from​ debt, we can compute the levered value of an​ investment, which is its value including the benefit of interest tax shields given the​ firm's leverage​ policy, by discounting its future free cash flow using the WACC. C. A​ project's cost of capital depends on its risk. D. The WACC incorporates the benefit of the interest tax shield by using the​ firm's before−tax cost of capital for debt.

D. The WACC incorporates the benefit of the interest tax shield by using the​ firm's before−tax cost of capital for debt.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. When a firm faces financial​ distress, it may choose not to finance​ new, positive−NPV projects. B. Agency costs represent another cost of increasing the​ firm's leverage that will affect the​ firm's optimal capital structure choice. C. An under−investment problem occurs when shareholders choose to not invest in a positive−NPV project. D. The agency costs of debt can arise only if there is no chance the firm will default and impose losses on its debt holders.

D. The agency costs of debt can arise only if there is no chance the firm will default and impose losses on its debt holders.

Which of the following is NOT one of the simplifying assumptions made for the three main methods of capital​ budgeting? Question content area bottom Part 1 A. Corporate taxes are the only market imperfection. B. The​ firm's debt−equity ratio is constant. C. The project has average risk. D. The firm pays out all earnings as dividends.

D. The firm pays out all earnings as dividends.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. To compute the increase in the​ firm's total value associated with the interest tax​ shield, we need to forecast a​ firm's debt and its interest payments. B. Given a forecast of future interest​ payments, we can determine the interest tax shield and compute its present value by discounting it at a rate that corresponds to its risk. C. There is an important tax advantage to the use of debt financing. D. The total value of the unlevered firm exceeds the value of the firm with leverage due to the present value of the tax savings from debt.

D. The total value of the unlevered firm exceeds the value of the firm with leverage due to the present value of the tax savings from debt.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. If bankruptcy is​ costly, these costs might offset the tax advantages of debt financing. B. While firms seem to prefer debt when raising external​ funds, not all investment is externally funded. C. Even though firms have not issued new​ equity, the market value of equity has risen over time as firms have grown. D. To receive the full tax benefits of leverage a firm needs to use​ 100% debt financing.

D. To receive the full tax benefits of leverage a firm needs to use​ 100% debt financing.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. Bankruptcy is a long and complicated process that imposes both direct and indirect costs on the firm and its investors that the assumption of perfect capital markets ignores. B. Bankruptcy is rarely simple and straightforward—equity holders​ don't just​ "hand the​ keys" to debt holders the moment the firm defaults on a debt payment. C. With perfect capital​ markets, the risk of bankruptcy is not a disadvantage of debt—bankruptcy simply shifts the ownership of the firm from equity holders to debt holders without changing the total value available to all investors. D. When a firm fails to make a required payment to debt​ holders, it is in bankruptcy.

D. When a firm fails to make a required payment to debt​ holders, it is in bankruptcy.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. An important consequence of leverage is the risk of bankruptcy. B. Modigliani and​ Miller's results continue to hold in a perfect market even when debt is risky and the firm may default. C. Economic distress is a significant decline in the value of a​ firm's assets, whether or not it experiences financial distress due to leverage. D. Whether default occurs depends on the cash​ flows, not on the relative values of the​ firm's assets and liabilities.

D. Whether default occurs depends on the cash​ flows, not on the relative values of the​ firm's assets and liabilities.

Which of the following statements is​ FALSE? Question content area bottom Part 1 A. In addition to the money spent by the​ firm, the creditors may incur costs during the bankruptcy process. B. The bankruptcy code is designed to provide an orderly process for settling a​ firm's debts. C. To ensure that their rights and interests are​ respected, and to assist in valuing their claims in a proposed​ reorganization, creditors may seek separate legal representation and professional advice. D. Whether paid by the firm or its​ creditors, the indirect costs of bankruptcy increase the value of the assets that the​ firm's investors will ultimately receive.

D. Whether paid by the firm or its​ creditors, the indirect costs of bankruptcy increase the value of the assets that the​ firm's investors will ultimately receive.

Consider the following​ equation: E​ + D​ = U​ = A The U in this equation​ represents: Question content area bottom Part 1 A. the value of the​ firm's equity. B. the market value of the​ firm's assets. C. the value of the​ firm's debt. D. the value of the​ firm's unlevered equity.

D. the value of the​ firm's unlevered equity.

For alt leverage policy, FTE method is usually most straightforward approach

FALSE, WACC preferred

MM prop 2: That support argument capital structure is irrelevant to value of the firm:

FALSE, proposition 1

MM Proposition 2: the proposition that supports the argument that the size of the pie does not depend on how pie is sliced

FALSE, that's mm prop 1

MM prop 2: Cost of equity depends on the returns of debt, the DE ratio, and tax rate:

False

Since debt has a lower cost than​ equity, the firm can reduce its capital costs by simply replacing equity with debt. Part 2 ​(Select the best choice​ below.) A. True B. False

False

The assumption that the firms DE ratio is constant means that risk of debt and equity will change when it accepts new projects

False

Underinvestment

Not investing in positive NPV projects

REVIEW MATH PROBLEMS FROM 14,15,16,18

REVIEW MATH PROBLEMS FROM 14,15,16,18

As a general rule, WACC method is easiest to use when firm maintains fixed DE over life of investment:

True

MM prop 2: the proposition hat the firms cost of equity cap is the position linear function of firms cap structure:

True

The assumption that the firms DE ratio is constant means that company's cost of capital will not fluctuate when it accepts new projects:

True

The chp 11 reorg plan specifies the treatment of each creditor of the firm. In addition to cash payment, creditor may receive new debt and equity or equity securities of the firm, the value of the cash and securities is less than the amount the holder is owed, but more than the amount the creditor would receive if shut down and liquidated :

True

When a company faces financial distress, shareholders have incentive to not invest and withdraw money from firm if possible

True

When used consistently, WACC, APV, FTE methods produce same valuation:

True

While developing a chapter 11 reorg plan, mgmt continues to operate the business. In the more common form of bankruptcy for large orgs, chp 11 reorg, all pending collection attempts are suspended and firms existing management is given op to propose reorg plan

True

Employee job security

highly leveraged firms run the risk of bankruptcy and so cannot write long term employment contracts and offer job security

Cashing out

paying out dividends instead of investing in positive NPV projects