Chapter 17 Financial Policies
The pecking-order theory predicts that profitable firms will use ___.
less leverage
Which of the following entities can file for bankruptcy protection?
Partnerships Corporations Municipalities
Which of the following is an example of "milking the property"?
Payment of excessive dividends to shareholders during financial distress
____ exists when a firm's manager knows more about the firm's prospects than the typical investor does.
Asymmetric information
What does the empirical data reveal about the relationship between access to free cash flow and bad acquisitions by the firm?
Bad acquisitions tends to increase as free cash flow increases.
What is the impact on the present value of distress costs as more debt is added?
It increases
The direct costs of Enron's bankruptcy were estimated to be:
$1 billion
Andrade and Kaplan estimate total distress costs to be between:
10 and 20 percent of firm value
How do bankruptcy costs affect bondholders and shareholders in the context of the distribution of firm value
Both bondholders and shareholders are adversely affected
What are some ways in which bondholders protect themselves from the selfish strategies of shareholders?
By not lending or lending selectively By lending at higher interest rates
True or false: Expert witnesses are professionals that are used by the corporation and the bondholders to evaluate the fairness of the bankruptcy settlement.
True
True or false: It is possible for the present value of distress costs to exceed the present value of tax savings.
True
True or false: Nonpayment of periodic interest on debt can lead to bankruptcy.
True
Which of the following factors affect the establishment of a target debt-equity ratio?
Type of assets, tangible or intangible Uncertainty of operating income Taxes
In 2010, the U.S. collected over $400 billion in corporate taxes. What do these figures suggest about the capital structure choices of U.S. firms?
U.S. firms do not use enough debt to capture all the tax shield benefits of debt.
A stock price fall may come from:
a decrease in debt
The payment to lawyers become relevant in the context of capital structure decisions in the event of ____.
financial distress
The debt tax shield increases the value of the ______ firm.
levered
If a firm is in financial distress and generates a $30 cash flow, what will be the total payment made to shareholders if the only remaining claimant on the firm's assets are the bondholders with a total claim of $40?
$0
Crane Co. has annual obligations of $30 towards interest and principal. and is forecasting a cash flow of either $25 (scenario I) or $50 (scenario 2) in the coming year. What will the payment to shareholders be in the two scenarios?
$0 in scenario 1 and $20 in scenario 2
What will the total payment to the bondholders be if a firm generates a cash flow of $100 but owes $150 to the bondholders in interest and principal repayment? Assume there are no costs of bankruptcy.
$100
The direct costs of Lehman Brother's bankruptcy were estimated to exceed ___.
$2.2 billion
If a firm is in financial distress, how much will the bondholders receive under the following scenario: expected cash available =$350; claims of bondholders =$275; claims of bankruptcy lawyers = $100?
$250
If a firm is in financial distress, how much will the bondholders receive under the following scenario: expected cash available =$140; claims of bondholders =$120; claims of bankruptcy lawyers = $80?
$60 Reason: $140 - 80 = $60
If a firm that has an annual debt obligation of $40 and generates cash flow of $30, how much will shareholders receive?
0
What is the optimal level of debt in a world with corporate taxes and no financial distress costs.
100% debt
What is a negative covenant?
A covenant that limits or prohibits actions that the company may take.
Which firm has a higher debt capacity?
A profitable firm
What is signaling?
Any announcement or action by the firm that conveys information to the market.
From a tax shield perspective, what is the expected relationship between a firm's profitability and its level of debt?
As profitability increases, a firm will increase the level of debt.
When is the present value of distress costs likely to exceed the present value of the tax shield from debt?
At high levels of debt
True or false: Protective covenants are classified as either direct or indirect covenants.
False Reason: Protective covenants are classified as either positive and negative covenants.
How does managerial ownership of equity affect the debt-equity ratio of real world companies?
Firms in which managers have high equity ownership tend to have lower leverage.
What is the likely impact on the work ethic of an employee once he acquires shares in the firm where he works?
He is likely to work harder.
Which of the following industries have high leverage ratios?
Hotel/gaming Building construction
Sam owns 2 percent of the firm he manages. What things might Sam be tempted to do that would benefit himself but increase his firm's agency costs?
Increase his work-related perquisites Take on unprofitable projects Increase his leisure time
Why do profitable firms tend to have more debt?
Interest expense generates tax savings.
According to the free cash flow hypothesis, which has the greater potential to reduce wasteful spending?
Interest on debt because interest is a legal obligation.
What are the advantages of using internal financing?
It prevents the adverse market reaction that tends to accompany a stock issue. It may be cheaper than debt or equity issues.
What is the most important benefit of debt?
It provides a tax benefit.
What is the benefit of bondholders owning shares during financial distress?
It reduces conflict between bondholders and shareholders.
According to the free cash flow hypothesis, how does the distribution of dividends benefit shareholders?
It reduces the amount of free cash flow available to managers for making bad acquisitions.
When bondholders own shares, it reduces the conflict between them and_________________.
Shareholders
Who are the main claimants of a firm's cash flows?
Stockholders Bondholders Government
Which of the following are consequences of nonpayment of debt obligations?
The firm will encounter some form of financial distress A firm may be forced to file for bankruptcy.
How do bankruptcy costs impact the distribution of firm value between shareholders and bondholders?
There is less left for shareholders and bondholders.
What is the expression for the value of a levered firm in the presence of corporate taxes?
Value of Levered Firm = Value of Unlevered Firm + Tax Benefit of Debt
It is virtually impossible to eliminate all ____________ costs.
agency
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
The value of a firm is equal to the value of its:
debt plus equity
Which of the following are differences between interest payments and dividend payments by the corporation?
dividend income is not fixed while interest income is generally fixed dividend payments are not an obligation but interest payments are an obligation dividends are paid to stockholders while interest is paid to bondholders
U.S. firms ______ use enough debt to capture all the tax shield benefits of debt.
do not
The empirical evidence on median debt-to-value ratios for countries around the world indicates that real world companies ___.
do not issue enough debt to significantly reduce or eliminate corporate taxes
When a firm issues equity, its share price tends too:
drop
The optimal level of debt in the presence of corporate taxes and bankruptcy costs occurs at the point at which the present value of distress costs _____ the present value of the tax shield benefits.
equals
No exact formula exists to evaluate the optimal debt-_____ ratio.
equity
The free cash flow hypothesis suggests that a shift from ______ to ______ will boost firm value.
equity; debt
An ____________ offer allows bondholders to exchange some of their debt for stock.
exchange
The weighted average cost of capital rises at higher levels of debt owing to:
financial distress costs
The value of a firm will ______ when the firm first uses leverage if we assume that there are no bankruptcy costs.
increase
An individual will work _______ if they own a ______ percentage of the company. less; larger
less; smaller harder; larger
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
A _______ covenant specifies actions that the firm agrees to take.
positive
An increase in the level of debt generally sends a(n) ______ signal to the market.
positive
Modigliani and Miller suggest that there is a(n) ______ relationship between leverage and firm value in the presence of corporate taxes.
positive
A _________ covenant is an agreement between bondholders and stockholders
protective
Cash dividends always ______ free cash flow.
reduce
Financial distress costs will ________ the value of the firm.
reduce
Increased monitoring will _____ agency costs.
reduce
Protective covenants should ______ the costs of bankruptcy.
reduce
The value of the firm is ______ by the agency costs of equity.
reduced
The tendency to work less because of the incentive structure is called ______________ behavior.
shirking
Academic studies find that direct costs of financial distress are _____ as a percentage of firm value.
small
What are some ways to reduce the agency costs of equity?
surveillance proper reporting
Highly profitable firms are likely to have higher debt ratios because they can deduct interest for _____ purposes.
tax
One of the important reasons why firms choose to raise capital by issuing debt is because of the ______ benefits of debt.
tax
A manager can benefit from pursuing negative NPV projects because ____.
the increase in firm size will likely lead to an increase in salary for the manager
Which theory implies a target level of debt?
trade-off theory
If a firm issues debt, shareholders will assume the firm's common stock is ______, and/but if a firm issues equity, shareholders will assume the firm's common stock is ______.
undervalued; overvalued
Given agency conflicts between shareholders and bondholders, which type of firm is likely to experience distortions in investment policy?
A levered firm
Which type of firm is more susceptible to selfish shareholder strategies?
A levered firm facing financial distress
Who is more likely to indulge in wasteful behavior?
A manager with a small ownership interest in the firm
Which of the following will increase the value of stocks and bonds?
A reduction in government taxes A reduction in the claims of lawyers
What theoretical assumptions will lead to all-debt financing by firms?
A world with corporate taxes but no financial distress costs
What are some covenant types that can prevent the transfer of corporate assets to shareholders?
Restrictions on the sale of assets Dividend restrictions
Which of the following industries have high leverage ratios?
Steel Homebuilding
What does the empirical data suggest about the market's reaction to exchange offer announcements that increase leverage?
Stock prices rise substantially on the date of the announcement.
How does the level of debt affect the weighted average cost of capital (WACC)?
The WACC initially falls and then rises as debt increases.
Which of the following is true after an LBO?
The company is owned by a few investors. The ownership pattern changes.
What are marketable claims?
These are claims that can be bought and sold in the market.
In a leveraged buyout (LBO), current shareholders are bought out at a price that is ____.
higher than the current market price
Which two of the following are broad types of costs of financial distress?
Direct costs Indirect costs
What is the consequence of breaking the bond covenant?
It can lead to default.
Why do firms prefer not to issue equity?
Share prices tend to drop when equity is issued.
______________ ultimately bear the cost of selfish strategies pursued by shareholders.
Shareholders
Who ultimately pays for the selfish strategies pursued by shareholders?
Shareholders Reason: Shareholders pay because bondholders require a higher return to compensate them for the possibility these strategies will be followed.
How does the concept of limited liability apply to shareholders?
Shareholders cannot be held personally liable for the debts of the corporation.
Which of the following are examples of investment policy distortion that can be caused by financial distress?
Shareholders may pursue high-risk projects that could hurt bondholders. Shareholders may forego profitable projects if some of the benefits have to be shared with bondholders. Shareholders may require additional dividend payments.
What are shareholders liable for if the firm is in financial distress and can pay only 80% of the payment due to the bondholders?
Since shareholders have limited liability, they are not personally responsible for the debt obligations of the firm.
Who is likely to have the most information about a firm's future prospects?
The firm's manager
How does the existence of debt reduce free cash flow?
The firm's obligation to make interest payments reduces free cash flow.
The value of the firm is given by the following expression:
firm value = value of equity + value of debt
As _________ cash flow increases, wasteful activity in the firm tends to increase.
free
In bankruptcy cases, the claims of lawyers are _____ the claims of senior bondholders.
given priority over
Nonmarketable claims include claims of the ____.
government lawyers
Industries with ______ levels of investment in tangible assets are likely to have higher debt ratios.
higher
The optimal debt-equity ratio will be ______ in a world with agency costs of equity than in a world without these costs.
higher
Shareholders bear the costs of selfish strategies through ___.
higher interest rates on bonds increased difficulty in selling bonds to raise money
In the real world, firms with high levels of investment in tangible assets will have ___.
higher target debt-equity ratios
In the presence of corporate taxes, the tax shield effect of debt will ____ the value of the firm.
increase
Protective covenants are most apt to ____ the value of a firm.
increase
Different creditors fighting with each other ______ bankruptcy costs.
increases
Volatility in income ______ the probability of financial distress.
increases
As firm size _____, managerial salaries tend to ______.
increases; increase
Based on the free cash flow hypothesis, firms should issue ______ debt.
more
Profitable firms will tend to have ______ debt than unprofitable firms.
more
The agency costs of equity makes debt financing _______ attractive.
more
Utilities tend to use ______ debt, relative to other industries.
more
Compared to the pharmaceutical industry, the utilities industry is likely to use more debt because operating income tends to be ___.
more stable
The possibility of bankruptcy costs has a(n) ______ effect on the value of the firm.
negative
When a firm announces an increase in debt, investors typically view this as:
positive
What are the two types of protective covenants?
positive covenants negative covenants
Firms with volatile operating income tend to have lower debt ratios because ___.
there is a higher probability of experiencing financial distress
Which of the following are examples of perquisites?
use of a company jet a big office a company car
In a world without bankruptcy costs or taxes, the value of the firm (the pie) is divided among which of the following?
Bondholders Stockholders
What are the two types of exchange offers?
Bondholders are allowed to exchange some of their debt for stock. Shareholders are allowed to exchange some of their stocks for debt.
What are the differences in the claims of shareholders and bondholders during bankruptcy?
Bondholders claims are settled first. Bondholders have a fixed claim while shareholders have a variable claim on all the residuals.
Under pecking order theory firms can choose between debt or equity for external financing, which will they prefer?
Debt
Why do firms prefer debt over equity as a source of external financing?
Equity has more risk than debt. Debt is less likely to be mispriced
MM's assertion of a positive relationship between firm value and leverage is widely observed in the business world.
False
What is financial slack?
It is excess cash accumulated by the firm.
What is the danger of having too much financial slack?
It may lead to wasteful investments or expenditures by managers.
What are the benefits of having fewer lenders during bankruptcy?
It reduces the conflicts among lenders. It makes it easier for the firm to negotiate with lenders.
Jackie, a sole proprietor, needs to raise $200,000 to expand her operations. Under which of the following financing arrangements is she likely to obtain more perquisites such as a lavish expense account?
Jackie brings in an additional partner and reduces her ownership share.
What is generally the most important component of direct costs of financial distress?
Legal costs
Which of the following are examples of covenants in loan contracts?
Limits on the sale of assets Maintenance of minimum working capital Dividend limitations
Why is MM's assertion about the positive relationship between firm value and leverage not observed in the real world?
MM did not consider bankruptcy costs.
What is management's attitude towards nonmarketed claims?
Management tries to reduce the value of nonmarketed claims.
Which one of the following is true about marketable claims?
Marketable claims can be bought and sold in financial markets.
Based on the trade-off theory, what should the managers attempt to maximize and minimize while developing capital structure policy?
Maximize the tax shield benefit of debt and minimize financial distress costs
Which of the following entities can file for bankruptcy protection?
Municipalities Partnerships Corporations
Given agency conflicts, why would shareholders tend to underinvest during times of financial distress?
New investment benefits the bondholders at the shareholder's expense
According to the pecking order theory, what is the preferred source for firms seeking to raise capital?
Retained earnings
What is the preferred source of financing for firms according to the pecking-order theory?
Retained earnings
Which of the following are examples of a negative covenant?
The firm is restricted from merging with another firm The firm may not pay excessive dividends
Which of the following are examples of a positive covenant?
The firm must maintain a debt ratio of 50%. The firm must furnish financial statements every quarter.
If a firm is in financial distress, who will get paid first?
The lawyers
What is the optimal level of debt?
The level of debt at which the marginal tax benefit of debt equals the marginal distress costs of debt
Why is a manager with a small ownership interest in the firm more likely to indulge in wasteful behavior?
The manager bears only a small fraction of the costs but enjoys all the benefits.
Why are managers likely to work harder after an LBO?
The managers have greater ownership interest.
What is the upper limit on payments to bondholders by the corporation regardless of the level of profits?
The obligation due in terms of interest and principal
What do Modigliani and Miller assert about the relationship between leverage and firm value in the presence of corporate taxes?
The value of the firm increases with leverage.
What do the academic studies conclude about the magnitude of direct costs of bankruptcy?
They are insignificant as a percentage of firm value.
What is the role of expert witnesses?
They testify about the fairness of a proposed settlement.
What is the benefit of writing protective and restrictive covenants into loan contracts?
They will lower the interest rate on bonds.
What are some possible consequences of raising debt to fool the market about a firm's value?
When the market discovers the truth, share prices will drop. The probability and expected costs of financial distress will increase if debt rises above the optimal level.
If the marginal tax benefit of debt is greater than the marginal cost of debt, the firm should:
add debt
As debt is ______ the capital structure, the present value of financial distress costs ______.
added to; increases
According to survey evidence, a ______ of firms have target debt ratios.
majority
A rational manager will try to maximize the value of ______ claims and minimize the value of ______ claims.
marketed; nonmarketed
Managers will try to ______ the value of marketed claims.
maximize
Paying out an extra dividend during financial distress is an example of shareholders " ___________ the property."
milking
According to the static theory, the optimal level of debt ______ the WACC.
minimizes
Most non financial companies issue ______ debt.
too little
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.
There _____ a danger to having too much financial slack.
is
True or false: There is a precise mathematical equation for determining the optimal level of debt for any firm.
False Reason: The optimal debt level is determined in a subjective manner. There is no precise equation.
Marketed claims can be bought and sold in _______________.
financial markets
Which of the following are examples of signaling by a firm?
An increase in dividends An increase in the target debt ratio
Protective covenants benefit shareholders by ____.
increasing firm value lowering interest rates on bonds
Investors react positively to an increase in a firm's level of debt because they expect the ___,
value of the firm to increase firm to generate tax savings
True or false: Very few firms in the real world have target debt ratios.
False
Financial slack helps firms avoid ___.
having to rely on external financing
After an LBO, managers are likely to shirk ___.
less
True or false: It is easy to measure indirect costs of financial distress.
False
A project costs $2,000 and will be financed by shareholders. The expected value of the shareholders' interest is $1,000 without the project and $2,500 with the project. Why will the shareholders reject this project?
The shareholders would invest $2,000 but receive only a $1,500 benefit. The bondholders would receive a $500 benefit at no cost to them.
What does a protective covenant involve?
The stipulation of actions that a company agrees to take The specification of conditions that a company must abide by
An example of an ______________ cost is when a firm issues more equity and an entrepreneur increases leisure time.
agency
During bankruptcy, the ownership of the firm's assets is transferred from stockholders to ___.
bondholders
Municipalities ______ file for bankruptcy.
can
When raising debt to fool the market, the stock price will _____ when the market realizes the company tried to fool it.
fall
Due too financial distress, shareholders may invest in ______ risk projects, at the expense of bondholders.
high
Firms in which managers have ______ equity ownership tend to have ______ leverage.
high; lower low; higher
Customers refusing to buy GM cars when it filed for Chapter 11 for fear of not being able to service the cars in the future is an example of ______ costs of financial distress
indirect
Many real-world companies base their capital structure decisions on ___.
industry averages
The trade-off theory implies that there is an optimal level of debt, but the pecking-order theory suggests that each firm chooses its leverage ratio based on ____.
its financing needs
Under the pecking order theory, profitable firms will tend to have ______ levels of debt.
lower
In the real world, firms with high levels of investment in research and development will have ___.
lower target debt-equity ratios
What is expropriation in the context of agency costs of the firm?
An improper transfer of wealth from bondholders to shareholders
Why would bondholders want to put restrictions on additional borrowing by the firm?
An increase in borrowing will dilute the claims of existing bondholders.
______ acquisitions tends to increase as free cash flow ______.
Bad; increase Good; decrease
What are some ways in which a bankruptcy filing might hinder a firm's normal business operations?
Banks may place restrictions on the firm's financial activities. Customers may not buy, fearing future service problems. Suppliers may not supply inventory, fearing nonpayment.
In the event of the liquidation of a firm, who gets paid first?
Bondholders
True or false: Corporate managers can consistently manipulate and fool the market.
False
True or false: In bankruptcy cases, different groups of creditors unite as one group.
False
True or false: Many real-world companies do not base their capital structure decisions on industry averages.
False
True or false: With appropriate measures, agency costs of equity can be eliminated.
False
What are the two components of the trade-off theory?
The tax benefits of debt and the costs of financial distress
What is shirking behavior?
The tendency to work less because of the incentive structure.
During times of financial distress, the selfish actions of shareholders may lead to the expropriation of wealth from ___.
bondholders
Capital structure ______ affect the value of marketable claims.
can
An increase in free _________ flow tends to increase wasteful spending.
cash
Firm value initially increases when the proportion of debt in the capital structure increases due to the ___.
debt tax shield
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
As debt ______, bankruptcy costs ______.
deceases; decrease increases; increase
A broken covenant can lead to ___________.
default
Financial distress costs are ______ to quantify.
difficult
Empirical studies suggest that the indirect costs of financial distress exceed the ______ costs of financial distress.
direct
Legal costs are typically the most important component of _________ costs.
direct
The two broad types of costs of financial distress are ___ costs.
direct and indirect
Financial _____________ costs lower the value of the levered firm.
distress
True or false: There is a precise mathematical equation that can be used to find the optimal debt-equity ratio for every firm.
low; higher high; lower
Bankruptcy costs are likely to be ______ if there are fewer groups of lenders.
lower
Industries with high growth rates are likely to have ______ debt ratios.
lower
Protective covenants typically ______ interest rates.
lower
