ch 12

Financial distress can lead to financial and operating "games." Which of the following statements is (are) true? . a. A firm's stockholders may prefer that the firm engage in riskier projects whereas the firm's bondholders may prefer that the firm invest in low-risk projects. b. The firm may underinvest in projects because the financing must be provided solely by the stockholders since it is unlikely the firm will be able to borrow additional funds. c. The firm may underinvest in projects because the financing must be provided solely by the bondholders since it is unlikely the firm will be able to issue additional stock. d. A firm's bondholders may prefer that the firm engage in riskier projects whereas the firm's stockholders may prefer that the firm invest in low-risk projects. e. Both (a) and (b)

. A firm's stockholders may prefer that the firm engage in riskier projects whereas the firm's bondholders may prefer that the firm invest in low-risk projects. b. The firm may underinvest in projects because the financing must be provided solely by the stockholders since it is unlikely the firm will be able to borrow additional funds. . Both (a) and (b)

A person's FICO score can range from: a. 300 to 850. b. 300 to 800. c. 600 to 850. d. 300 to 600.

300 to 850.

Which statement is TRUE regarding a firm that increases financial leverage? a. Average earnings per share increases, while shareholder risk increases. b. Average earnings per share increases, while shareholder risk decreases. c. Average earnings per share decreases, while shareholder risk decreases. d. Average earnings per share decreases, while shareholder risk increases.

Average earnings per share increases, while shareholder risk increases.

Which statement is FALSE concerning capital structure? a. Firms with large amounts of tangible assets tend to use a lot of debt in their capital structures. b. When corporate profits are taxed at the corporate and personal level, the benefits of leverage are greatly reduced. c. Modern trade off theory predicts that a firm's optimal debt level is set by trading off the tax benefits of leverage against the agency costs of increased debt. d. Debt is used more frequently abroad (such as Germany and England) as international laws tend to favor debtors.

Debt is used more frequently abroad (such as Germany and England) as international laws tend to favor debtors.

If a firm increases its financial leverage, then what would we generally expect for the effect of that increased leverage on EPS to be if the firm's EPS is already quite high? a. EPS would be lower with financial leverage b. EPS would always be the same with financial leverage c. EPS would be higher with financial leverage d. it is not possible to determine

EPS would be higher with financial leverage

If a firm increases its use of financial leverage, then what would we generally expect for the effect of that increased leverage to have on an EPS that is already very low? a. EPS would be lower with financial leverage b. EPS would always be the same with financial leverage c. EPS would be higher with financial leverage d. it is not possible to determine

EPS would be lower with financial leverage

Which statement is FALSE regarding empirical evidence of capital structures? a. Capital structures show strong industry patterns. b. Economy wide leverage ratios are consistent across countries. c. Leverage ratios are negatively related to the cost of financial distress. d. Within industries, the most profitable companies borrow the least.

Economy wide leverage ratios are consistent across countries.

The proposition that the market value of the firm is independent of its capital structure is called . . . a. M&M proposition I b. M&M proposition II c. the capital asset pricing model d. none of the above

M&M proposition I

Which of the following is considered a direct cost of bankruptcy? a. diversion of management's time b. constrained capital investment spending c. lost sales d. none of the above

None of the above

A graphical representation of The Trade-Off Model is shown. Various components of the graph are labeled. Which of the following corresponds to line 1? a. Present value of interest tax shields on debt b. Present value of expected bankruptcy and agency costs c. Value of levered firm with bankruptcy costs d. Value of levered firm in the absence of bankruptcy and agency costs e. Value of firm under all-equity financing

Present value of expected bankruptcy and agency costs

A graphical representation of The Trade-Off Model is shown. Various components of the graph are labeled. Which of the following corresponds to line 2? a. Present value of interest tax shields on debt b. Present value of expected bankruptcy and agency costs c. Value of levered firm with bankruptcy costs d. Value of levered firm in the absence of bankruptcy and agency costs e. Value of firm under all-equity financing

Present value of interest tax shields on debt

Firm Y issued $100,000,000 of bonds last year for the purpose of building a new widget manufacturing plant. Firm Y instead used the proceeds to fund Blackjack gamblers in Las Vegas. Which of the following best describes the general problem that Y's investors must deal with? a. The Underinvestment Problem b. The Overinvestment Problem c. The Asset Substitution Problem d. The Enron Problem

The Asset Substitution Problem

In a world with only company-level taxation of operating profits, no costs of bankruptcy, and tax-deductible interest payments, what is the optimal corporate strategy? a. The firm should use all equity to maximize firm value. b. The firm should use all debt to maximize its value. c. The firm's value is independent of the way it is financed. d. The firm should maximize the use of preferred stock to create value.

The firm should use all debt to maximize its value.

Which statement correctly describes proposition I of Modigliani and Miller? a. The value of the firm is independent of its capital structure. b. If there is no default risk, firms should exclusively use debt to finance projects. c. If there is no default risk, firms should exclusively use equity to finance projects. d. The value of the firm's tax shields depends solely on the amount of debt issued.

The value of the firm is independent of its capital structure.

A graphical representation of The Trade-Off Model is shown. Various components of the graph are labeled. Which of the following corresponds to line 5? a. Present value of interest tax shields on debt b. Present value of expected bankruptcy and agency costs c. Value of levered firm with bankruptcy costs d. Value of levered firm in the absence of bankruptcy and agency costs e. Value of firm under all-equity financing

Value of firm under all-equity financing

A graphical representation of The Trade-Off Model is shown. Various components of the graph are labeled. Which of the following corresponds to line 3? a. Present value of interest tax shields on debt b. Present value of expected bankruptcy and agency costs c. Value of levered firm with bankruptcy costs d. Value of levered firm in the absence of bankruptcy and agency costs e. Value of firm under all-equity financing

Value of levered firm in the absence of bankruptcy and agency costs

A graphical representation of The Trade-Off Model is shown. Various components of the graph are labeled. Which of the following corresponds to line 4? a. Present value of interest tax shields on debt b. Present value of expected bankruptcy and agency costs c. Value of levered firm with bankruptcy costs d. Value of levered firm in the absence of bankruptcy and agency costs e. Value of firm under all-equity financing

Value of levered firm with bankruptcy costs

48. You are evaluating a company and have found a new way to calculate the present value of bankruptcy costs, agency costs of outside equity as well as debt. You find that the agency costs of outside equity is $100 while the agency cost of outside debt is $1,000,000. The costs of bankruptcy are also $1,000,000. What type of firm does most likely describe? a. a firm with too little leverage b. a firm with too much leverage c. a firm with too much equity d. a firm that should disregard its agency costs

a firm with too much leverage

The issue of corporate capital structure has similarities to college students' financial situations because: a. Many students use borrowed funds to finance their education. b. Most finance students will ultimately work for a major corporation and will make decisions as to how the firm finances its investment in assets. c. using debt to finance one's education is similar to issuing stock to finance investment in a firm's assets d. both (a) and (c)

a. Many students use borrowed funds to finance their education. c. using debt to finance one's education is similar to issuing stock to finance investment in a firm's assets both (a) and (c)

Financial distress can be particularly dangerous to firms that produce R&D- intensive goods and services because: a. Most of the expenses incurred in production are sunk costs. b. It is unlikely to be able to fund future R&D expenditures if it is in financial distress meaning that it is probably not going to be able to produce cutting-edge products in the future. c. Intangible assets such as patents and trademarks are unlikely to survive the bankruptcy or financial distress intact. d. all of the above e. both (a) and (b)

a. Most of the expenses incurred in production are sunk costs. b. It is unlikely to be able to fund future R&D expenditures if it is in financial distress meaning that it is probably not going to be able to produce cutting-edge products in the future. c. Intangible assets such as patents and trademarks are unlikely to survive the bankruptcy or financial distress intact. all of the above

Which of the following statements is true? a. The use of debt may lead to financial distress and bankruptcy, thus firms that sell expensive, durable products that may have warranties and ongoing service requirements tend to use less debt. b. The use of debt may lead to financial distress and bankruptcy, thus firms that sell expensive, durable products that may have warranties and ongoing service requirements tend to use more debt. c. Companies with a large proportion of tangible assets should be more willing to use debt than firms with mostly intangible assets. d. Companies with a large proportion of tangible assets should be less willing to use debt than firms with mostly intangible assets. e. Both (a) and (c)

a. The use of debt may lead to financial distress and bankruptcy, thus firms that sell expensive, durable products that may have warranties and ongoing service requirements tend to use less debt. c. Companies with a large proportion of tangible assets should be more willing to use debt than firms with mostly intangible assets. Both (a) and (c)

In examining the question as to whether or not capital structures are randomly selected, we generally find that: a. capital structures show strong industry patterns. b. within industries, the most profitable companies borrow the least. c. corporate and personal income taxes influence capital structures, but taxes alone cannot explain differences in leverage across firms, industries or countries. d. shareholders consider leverage-increasing events to be "good news" and leverage-decreasing events to be "bad news." e. All of the above

a. capital structures show strong industry patterns. b. within industries, the most profitable companies borrow the least. c. corporate and personal income taxes influence capital structures, but taxes alone cannot explain differences in leverage across firms, industries or countries. d. shareholders consider leverage-increasing events to be "good news" and leverage-decreasing events to be "bad news." All of the above

The FICO score: a. was developed by Fair Isaac & Company b. is based on a person's income and overall indebtedness, the type of debt outstanding and the monthly payment amounts. c. can have a large impact on the interest rate a person is charged on their mortgage. d. all of the above e. (b) and (c) only

a. was developed by Fair Isaac & Company b. is based on a person's income and overall indebtedness, the type of debt outstanding and the monthly payment amounts. c. can have a large impact on the interest rate a person is charged on their mortgage. all of the above

The agency costs of (outside) equity can result in: a. a benefit to society in the sense that the firm can raise external equity thus generating additional funds that can be invested. b. a cost to society because the market value of corporate assets is reduced. c. entrepreneurs paying less than 100% of the cost of consuming perquisites. d. all of these e. none of these

all of these a. a benefit to society in the sense that the firm can raise external equity thus generating additional funds that can be invested. b. a cost to society because the market value of corporate assets is reduced. c. entrepreneurs paying less than 100% of the cost of consuming perquisites.

The uncertainty caused by the variability of a firm's cash flows is called . . . a. financial risk b. business risk c. financial leverage d. none of the above

business risk

If a firm increases its use of financial leverage, then what would we generally expect for the effect of that increased leverage to have on the dispersion of the firm's Net Income distribution? a. less dispersion b. no effect on dispersion c. greater dispersion d. there is not enough information to determine

greater dispersion

Firm X plans to increase its financial leverage by issuing debt and using the proceeds to repurchase equity. If you assume that the Modigliani and Miller assumptions hold, then the effect of this increasing financial leverage transaction should a. increase the market value of Firm X's shares. b. have no effect on the market value of Firm X's shares. c. decrease the market value of Firm X's shares. d. it is not possible to tell what will happen.

have no effect on the market value of Firm X's shares.

40. If we start with the M&M perfect capital markets assumption and then relax the no tax assumption on corporations, then we would expect for firms that go from no leverage to some leverage to a. have the levered version of the firm at least as valuable as the no-leverage firm. b. have the no-leverage version of the firm at least as valuable as the levered firm. c. change in value depending upon the level of personal taxes. d. none of the above.

have the levered version of the firm at least as valuable as the no-leverage firm.

If a firm increases its use of financial leverage, then what would we generally expect for the shareholders of that firm to a. lower their demand for return on their investment. b. remain indifferent with respect to their return on investment. c. increase their demand for return on their investment. d. it is not possible to tell what will happen.

increase their demand for return on their investment.

Costs associated with the requirement that management divert its attention away from strategically managing a corporation in favor of spending time with financial attorneys could be best described as a. direct bankruptcy costs. b. indirect bankruptcy costs. c. managerial-shareholder related agency costs. d. none of the above.

indirect bankruptcy costs.

Which of the following is considered an indirect cost of bankruptcy? a. document printing expenses b. professional fees paid to lawyers c. loss of key employees d. none of the above

loss of key employees

Perfect capital markets describe markets without frictions such as a. taxes. b. trading costs. c. problems transferring information between managers and investors. d. all of the above.

taxes. trading costs. problems transferring information between managers and investors. all of the above.

If you were to look at leverage for companies in a country where there is a very high cost of attorneys and accountants, all other things being equal you would expect a. that firms in those countries would utilized less leverage than in other countries. b. that firms in those countries would utilized more leverage than in other countries. c. that firms in those countries would utilize no leverage. d. that firms in those countries would utilize as much leverage as is mathematically possible.

that firms in those countries would utilized less leverage than in other countries.

A situation where shareholders refuse financing a "good" investment, because they think that only the bondholders will benefit will lead to . . a. asset substitution b. underinvestment c. overinvestment d. none of the above

underinvestment

One method of preventing or reducing the chance that corporate management will harm the bondholders to the benefit of the stockholders is to: a. require that key executives own a certain percentage of the firm's outstanding stock b. require that key executives own a certain percentage of the firm's outstanding bonds c. write detailed covenants into bond contracts. d. all of the above are acceptable methods

write detailed covenants into bond contracts.