Downsides of Debt

Which one of the following is true? (a)A firm with low anticipated profits will likely take on a high level of debt. (b)Investors will generally view an increase in leverage as a positive sign of the firm's value. (c)Rational investors are likely to infer a higher firm value if a firm is all-equity financed. (d)Rational firms raise debt levels when profits are expected to decline. (e)High-growth firms with future positive net present value projects tend to have high levels of debt.

(b) Investors will generally view an increase in leverage as a positive sign of the firm's value.

Which one of these represents an indirect cost of financial distress?

A firm's supplier requiring payment in cash rather than offering its normal credit terms

Which one of the following statements concerning bankruptcy is correct?

An indirect cost of bankruptcy is the loss of key employees.

Which one of these statements is a correct implication of the pecking order theory?

Companies like financial slack so they can reduce their external capital needs.

Which of the following are common loan covenants? Assume each item applies only during the term of the loan. I. Limit on future borrowing II. Requirement that the borrower maintains a minimum stated level of net working capital III. Limit on any sales or switches of assets IV. Limit on the amount of dividends that can be paid

I, II, III, and IV

Which of these will occur in a world with taxes and financial distress when a firm is operating at its optimal capital structure? I. The debt-equity ratio will be optimal. II. The weighted average cost of capital will be at its minimal point. III. The required return on assets will be at its maximum point. IV. The increased benefit from additional debt will equal the increased bankruptcy costs of that debt.

I, II, and IV only

Which one of these actions by a firm is an example of milking the property? Assume the firm is in a period of financial distress.

Paying an extra dividend

Conflicts of interest between stockholders and bondholders are known as

agency costs.

The legal proceeding for liquidating or reorganizing a firm operating in default is called a

bankruptcy.

The protective covenants contained within a loan agreement

can increase the value of the borrowing firm.

The optimal capital structure has been achieved when the

debt-equity ratio selected results in the lowest possible weighted average cost of capital.

The explicit costs, such as the legal expenses, associated with corporate default are classified as _____ costs.

direct bankruptcy

A firm that has a negative net worth is said to be

experiencing accounting insolvency.

The explicit and implicit costs associated with corporate default are referred to as the _____ costs of a firm.

financial distress

Indirect bankruptcy costs

include the costs incurred by a firm as it tries to avoid seeking bankruptcy protection.

The costs of avoiding a bankruptcy filing by a financially distressed firm are classified as _____ costs.

indirect bankruptcy

A firm is technically insolvent when:

it is unable to meet its financial obligations.

In principle, a firm becomes bankrupt when

its equity value falls to zero.

The complete termination of a firm as a going business concern is called a

liquidation.

The optimal capital structure will tend to include more debt for firms with

lower probability of financial distress.

The pecking order theory states that when external funds are required, a firm should

only issue equity securities after the firm's debt capacity is reached.

A legal attempt to financially restructure a failing firm so that it can continue operating as a going concern is called a

reorganization.

Corporations in the U.S. tend to

underutilize debt.

The pecking order theory identifies two rules. The first rule is to

use internal financing prior to external financing.

In general, the capital structures of U.S. firms:

vary significantly across industries.

The value of a firm is maximized when the

weighted average cost of capital is minimized.

The optimal capital structure of a firm

will vary over time as taxes and market conditions change.