chp 17

positive

A _______ covenant specifies actions that the firm agrees to take.

company

A negative covenant restricts the actions of the ______

a decrease in debt

A stock price fall may come from:

small

Academic studies find that direct costs of financial distress are _____ as a percentage of firm value.

It reduces the amount of free cash flow available to managers for making bad acquisitions.

According to the free cash flow hypothesis, how does the distribution of dividends benefit shareholders?

False

In bankruptcy cases, different groups of creditors unite as one group.

increase

Protective covenants are most apt to ____ the value of a firm.

lowering interest rates on bonds increasing firm value

Protective covenants benefit shareholders by ____.

reduce

Protective covenants should ______ the costs of bankruptcy.

financial distress costs

The weighted average cost of capital rises at higher levels of debt owing to:

is

There _____ a danger to having too much financial slack.

false

There is a precise mathematical equation that can be used to find the optimal debt-equity ratio for every firm.

higher interest rates on bonds increased difficulty in selling bonds to raise money

Shareholders bear the costs of selfish strategies through ___.

$1 billion

The direct costs of Enron's bankruptcy were estimated to be:

$2.2 billion

The direct costs of Lehman Brother's bankruptcy were estimated to exceed ___.

less leverage

The pecking-order theory predicts that profitable firms will use ___.

only after internal funds are exhausted

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 ___.

more

Utilities tend to use ______ debt, relative to other industries.

increases

Volatility in income ______ the probability of financial distress.

Since shareholders have limited liability, they are not personally responsible for the debt obligations of the firm.

What are shareholders liable for if the firm is in financial distress and can pay only 80% of the payment due to the bondholders?

By lending at higher interest rates By not lending or lending selectively

What are some ways in which bondholders protect themselves from the selfish strategies of shareholders?

Steel Homebuilding

Which of the following industries have high leverage ratios?

the increase in firm size will likely lead to an increase in salary for the manager It is virtually impossible to eliminate all agency costs

A manager can benefit from pursuing negative NPV projects because ____.

Interest on debt because interest is a legal obligation.

According to the free cash flow hypothesis, which has the greater potential to reduce wasteful spending?

minimizes

According to the static theory, the optimal level of debt ______ the WACC.

Debt is less likely to be mispriced Equity has more risk than debt.

Why do firms prefer debt over equity as a source of external financing?

The manager bears only a small fraction of the costs but enjoys all the benefits.

Why is a manager with a small ownership interest in the firm more likely to indulge in wasteful behavior?

Bad; increase Good; decrease

______ acquisitions tends to increase as free cash flow ______.

less

After an LBO, managers are likely to shirk ___.

government lawyers

Nonmarketable claims include claims of the ____.

trade-off theory

Which theory implies a target level of debt?

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.

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?

Retained earnings

According to the pecking order theory, what is the preferred source for firms seeking to raise capital?

a firm issues more equity and an entrepreneur increases leisure time.

An example of an agency cost is when

10 and 20 percent of firm value

Andrade and Kaplan estimate total distress costs to be between:

Jackie brings in an additional partner and reduces her ownership share.

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?

false

MM's assertion of a positive relationship between firm value and leverage is widely observed in the business world.

industry averages

Many real-world companies base their capital structure decisions on ___.

false

Many real-world companies do not base their capital structure decisions on industry averages.

positive

Modigliani and Miller suggest that there is a(n) ______ relationship between leverage and firm value in the presence of corporate taxes.

tax

One of the important reasons why firms choose to raise capital by issuing debt is because of the ______ benefits of debt.

"milking the property."

Paying out an extra dividend during financial distress is an example of shareholders

false

Protective covenants are classified as either direct or indirect covenants.

would benefit himself but increase his firm's agency costs? Increase his leisure time Increase his work-related perquisites Take on unprofitable projects

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?

do not issue enough debt to significantly reduce or eliminate corporate taxes

The empirical evidence on median debt-to-value ratios for countries around the world indicates that real world companies ___.

equity; debt

The free cash flow hypothesis suggests that a shift from ______ to ______ will boost firm value.

do not

U.S. firms ______ use enough debt to capture all the tax shield benefits of debt.

debt

Under pecking order theory firms can choose between debt or equity for external financing, which will they prefer?

lower

Under the pecking order theory, profitable firms will tend to have ______ levels of debt.

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.

What are some possible consequences of raising debt to fool the market about a firm's value?

Customers may not buy, fearing future service problems. Suppliers may not supply inventory, fearing nonpayment. Banks may place restrictions on the firm's financial activities.

What are some ways in which a bankruptcy filing might hinder a firm's normal business operations?

proper reporting surveillance

What are some ways to reduce the agency costs of equity?

It prevents the adverse market reaction that tends to accompany a stock issue. It may be cheaper than debt or equity issues

What are the advantages of using internal financing?

It reduces the conflicts among lenders. It makes it easier for the firm to negotiate with lenders.

What are the benefits of having fewer lenders during bankruptcy?

The tax benefits of debt and the costs of financial distress

What are the two components of the trade-off theory?

the managers

Who owns most of the firm after an LBO?

lower

Bankruptcy costs are likely to be ______ if there are fewer groups of lenders

more

Based on the free cash flow hypothesis, firms should issue ______ debt.

high

Due too financial distress, shareholders may invest in ______ risk projects, at the expense of bondholders.

there is a higher probability of experiencing financial distress

Firms with volatile operating income tend to have lower debt ratios because ___

As profitability increases, a firm will increase the level of debt.

From a tax shield perspective, what is the expected relationship between a firm's profitability and its level of debt?

higher

The optimal debt-equity ratio will be ______ in a world with agency costs of equity than in a world without these costs

equals

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

financial distress

The payment to lawyers become relevant in the context of capital structure decisions in the event of ____.

shirking behavior

The tendency to work less because of the incentive structure is called

direct and indirect

The two broad types of costs of financial distress are ___ costs.

positive covenants negative covenants

What are the two types of protective covenants?

At high levels of debt Financial distress costs lower the value of the levered firm.

When is the present value of distress costs likely to exceed the present value of the tax shield from debt?

fall

When raising debt to fool the market, the stock price will _____ when the market realizes the company tried to fool it.

The firm will encounter some form of financial distress A firm may be forced to file for bankruptcy.

Which of the following are consequences of nonpayment of debt obligations?

The firm is restricted from merging with another firm The firm may not pay excessive dividends

Which of the following are examples of a negative covenant?

Shareholders may forego profitable projects if some of the benefits have to be shared with bondholders. Shareholders may pursue high-risk projects that could hurt bondholders. Shareholders may require additional dividend payments.

Which of the following are examples of investment policy distortion that can be caused by financial distress?

a company car a big office use of a company jet

Which of the following are examples of perquisites?

An increase in the target debt ratio An increase in dividends

Which of the following are examples of signaling by a firm?

Corporations Municipalities Partnerships

Which of the following entities can file for bankruptcy protection?

Stockholders Bondholders Government

Who are the main claimants of a firm's cash flows?

lost sales lost reputation

what are some examples of indirect financial distress costs?

Maximize the tax shield benefit of debt and minimize financial distress costs

Based on the trade-off theory, what should the managers attempt to maximize and minimize while developing capital structure policy?

reduce

Financial distress costs will ________ the value of the firm.

lower

Industries with high growth rates are likely to have ______ debt ratios. lower

They testify about the fairness of a proposed settlement.

What is the role of expert witnesses?

positive

When a firm announces an increase in debt, investors typically view this as:

False

Bondholders cannot restrict a firm's future borrowing decisions.

protective covenants

Bonds with ____ will be issued at a relatively low interest rates.

more stable

Compared to the pharmaceutical industry, the utilities industry is likely to use more debt because operating income tends to be ___.

$0 in scenario 1 and $20 in scenario 2

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?

bondholders

During bankruptcy, the ownership of the firm's assets is transferred from stockholders to ___.

having to rely on external financing

Financial slack helps firms avoid ___.

high; lower low; higher

Firms in which managers have ______ equity ownership tend to have ______ leverage.

Shareholders cannot be held personally liable for the debts of the corporation.

How does the concept of limited liability apply to shareholders?

The firm's obligation to make interest payments reduces free cash flow.

How does the existence of debt reduce free cash flow?

The WACC initially falls and then rises as debt increases.

How does the level of debt affect the weighted average cost of capital (WACC)?

40

If a firm has annual debt obligations of $50 to the bondholders and generates cash flow of $40, how much will the bondholders receive?

the lawyers

If a firm is in financial distress, who will get paid first?

undervalued; overvalued

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 ______.

U.S. firms do not use enough debt to capture all the tax shield benefits of debt.

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?

higher than the current market price

In a leveraged buyout (LBO), current shareholders are bought out at a price that is ____.

principal delegates decision making authority to an agent

In an agency relationship the:

given priority over

In bankruptcy cases, the claims of lawyers are _____ the claims of senior bondholders.

lower target debt-equity ratios

In the real world, firms with high levels of investment in research and development will have ___.

higher target debt-equity ratios

In the real world, firms with high levels of investment in tangible assets will have ___.

higher

Industries with ______ levels of investment in tangible assets are likely to have higher debt ratios.

debt plus equity

The value of a firm is equal to the value of its:

increase

The value of a firm will ______ when the firm first uses leverage if we assume that there are no bankruptcy cost

reduced

The value of the firm is ______ by the agency costs of equity.

firm value = value of equity + value of debt

The value of the firm is given by the following expression:

A claim that cannot be traded on the market.

What is a nonmarketable claim?

It is excess cash accumulated by the firm

What is financial slack?

invest in risky projects

When a firm is in financial distress, the shareholders have an incentive to:

High risk projects tend to transfer wealth from the bondholders to the shareholders.

Why do bond covenants restrict high risk investments by shareholders during financial distress?

New investment benefits the bondholders at the shareholder's expense

Given agency conflicts, why would shareholders tend to underinvest during times of financial distress?

Both bondholders and shareholders are adversely affected

How do bankruptcy costs affect bondholders and shareholders in the context of the distribution of firm value

Firms in which managers have high equity ownership tend to have lower leverage.

How does managerial ownership of equity affect the debt-equity ratio of real world companies?

$250

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?

They are insignificant as a percentage of firm value.

What do the academic studies conclude about the magnitude of direct costs of bankruptcy?

The stipulation of actions that a company agrees to take The specification of conditions that a company must abide by

What does a protective covenant involve?

Bad acquisitions tends to increase as free cash flow increases.

What does the empirical data reveal about the relationship between access to free cash flow and bad acquisitions by the firm?

Stock prices rise substantially on the date of the announcement.

What does the empirical data suggest about the market's reaction to exchange offer announcements that increase leverage?

An improper transfer of wealth from bondholders to shareholders

What is expropriation in the context of agency costs of the firm?

Management tries to reduce the value of nonmarketed claims

What is management's attitude towards nonmarketed claims?

The tendency to work less because of the incentive structure.

What is shirking behavior?

Any announcement or action by the firm that conveys information to the market.

What is signaling?

It reduces conflict between bondholders and shareholders

What is the benefit of bondholders owning shares during financial distress?

They will lower the interest rate on bonds.

What is the benefit of writing protective and restrictive covenants into loan contracts?

It can lead to default.

What is the consequence of breaking the bond covenant?

It may lead to wasteful investments or expenditures by managers.

What is the danger of having too much financial slack?

There is no limit on the payments to shareholders; there is a fixed upper limit on the payments to bondholders.

What is the difference in the limits on the payments to shareholders and bondholders?

Value of Levered Firm = Value of Unlevered Firm + Tax Benefit of Debt

What is the expression for the value of a levered firm in the presence of corporate taxes?

The firm loses the valuable tax shield benefits of debt.

What is the main drawback of not issuing debt so as to avoid bankruptcy costs?

100% debt

What is the optimal level of debt in a world with corporate taxes and no financial distress costs.

Retained earnings

What is the preferred source of financing for firms according to the pecking-order theory?

There is no upper limit.

What is the upper limit on a payment to common stockholders?

The obligation due in terms of interest and principal

What is the upper limit on payments to bondholders by the corporation regardless of the level of profits?

A world with corporate taxes but no financial distress costs

What theoretical assumptions will lead to all-debt financing by firms?

$100

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.

At high levels of debt

When is the present value of distress costs likely to exceed the present value of the tax shield from debt?

Taxes Type of assets, tangible or intangible Uncertainty of operating income

Which of the following factors affect the establishment of a target debt-equity ratio?

Payment of excessive dividends to shareholders during financial distress

Which of the following is an example of "milking the property"?

The ownership of assets is transferred from the shareholders to the bondholders

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.

Which of the following is likely to be true when a bankruptcy ruling is issued?

The ownership pattern changes. The company is owned by a few investors.

Which of the following is true after an LBO?

A reduction in government taxes A reduction in the claims of lawyers

Which of the following will increase the value of stocks and bonds?

Marketable claims can be bought and sold in financial markets.

Which one of the following is true about marketable claims?

The static trade-off theory of capital structure

Which theory of capital structure leads to a target debt ratio

A manager with a small ownership interest in the firm

Who is more likely to indulge in wasteful behavior

Shareholders

Who ultimately pays for the selfish strategies pursued by shareholders?

The managers have greater ownership interest.

Why are managers likely to work harder after an LBO?

The shareholders have will lose no more than they've already lost. High-risk projects offer the potential for a higher return for shareholders

Why are shareholders more keen on investing in high-risk projects during times of financial distress?