Financial Policies FINAL Ch 17

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

$1 billion

Firm B uses no debt. If tax rate on corp. income is 30% and personal tax rate on interest income and divd income is 15%, what is the net CF to firms B shareholders if pretax earnings are $100?

$100 x (1-.30) x (1-.15) = $59.50

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 BH receive under the following scenario: exp cash available = $140; claims of BH = $120; claims of bankruptcy laywers = $80

$60

What are the two types of exchange offers?

- SH can exchange some of their stocks for debt - BH can exchange some debt for stock

Examples of investment policy distortion that can be caused by financial distress:

- SH may pursue high risk projects that could hurt BH - SH may require addt dividend payments - SH may forego profitable projects if some of the benefits have to be shared with BH

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?

- SH would invest $2,000 but receive only a $1,500 benefit - The BH would receive a $500 benefit at no cost to them

Consequences of nonpayment of debt obligations

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

Academic studies conclude _______ about the magnitude of direct costs of bankruptcy.

- They are insignificant as a percentage of firm value

Relationship between access to free CFs and bad acquisitions by the firm:

- bad acquisitions tend to increase as free CF increases

Which of the following industries have high leverage ratios?

- building construction - air transport

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

- by not lending or lending selectively - by lending at higher interest rates

Which is true after an LBO?

- company is owned by fewer investors - ownership pattern changes

Which entities can file for bankruptcy?

- corporations -municipalities - partnerships

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

- equity as more risk - debt is less likely to be mispriced

Which of the following are examples of a negative covenant?

- firm may not pay excessive divds - firm is restricted from merging with another firm

examples of a positive covenant?

- firm must maintain a debt ratio of 50% - firm must furnish financial statements every quarter

SH bear the costs of selfish strategies through __________.

- higher interest rates on bonds - increase difficulty in selling bonds to raise money

Sam owns 2% 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 - increase his leisure time - take on unprofitable projects

Examples of covenants in loan contracts:

- limits on the sale of assets - maintenance of minimum working capital - dividend limitations

Examples of indirect financial distress costs:

- lost reputation - lost sales

What type of covenants may restrict SH from pursuing high-risk investments during financial distress?

- min net worth restrictions - min interest coverage restrictions

Which of the following are examples of efforts to reduce agency costs between shareholders and the managers?

- periodic reports by managers - performance based bonus - stock options plan

Advantages of using internal financing:

- prevents mkt reaction that tends to accompany a stock issue - may be cheaper that debt or equity

Benefits of having fewer lenders during bankruptcy?

- reduces conflicts among lenders - makes it easier for firm to negotiate with lenders

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

- the SH have no more to lose - high-risk projects offer potential for higher return for SH

A manager can benefit from pursing neg NPV projects because _____________.

- the increase in firm size will likely lead to an increase in salary for the manager

Andrade and Kaplan estimate total distress costs to be between

10 and 20% of firms value

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

An improper transfer of wealth from BH to SH

Who pays to gain privilege of receiving CFs in future?

BH and SH

Assume firm A is all equity and firm B is all debt. If the tax rate on corporate income is 35%, what is the distribution to shareholders in firm A and BH in firm B if both firms earn pre-tax income of $100.

BH receive $100 while shareholders receive $65.

What is financial slack?

Excess cash

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

False

True or False: There is a precise math equation used to find the optimal d-e ratio for every firm.

False

True or False: Very few firms in the real world have target debt ratios

False

True or False: Protective covenants are classified as either direct or indirect covenants

False; positive or negative

What is the impact on PV of distress costs as more debt is added?

Increase

What is generally the most important component of direct costs of financial distress?

Legal costs

How do bankruptcy costs impact the distribution between SH and BH?

Less left for SH and BH

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

Retained earnings

Preferred source of financing for firms according to pecking order theory?

Retained earnings

Who ultimately pays for the selfish strategies pursued by SH?

SH

True or False: Expert witnesses are professionals that are used by the corporation and the BH to evaluate the fairness of the bankruptcy settlement.

True

True or False: Nonpayment of periodic interest on debt can lead to bankruptcy.

True

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

Value of levered firm = value of unlevered + tax benefit of debt

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

a world with corp taxes but no fin distress costs

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

at high levels of debt

In a shareholder-bondholder relationship, the __________ is the principal.

bondholder

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

bondholders

Consequence of breaking the bond covenant?

can lead to default

In a world with no financial distress where divds and interest are taxes the same, firms will prefer to issue __________

debt

If a firm issues _____________, SH will assume the firm's C.S. is undervalued; If firm issues _____________, SH assume firm's C.S. is overvalued.

debt; equity

Why is MM's assertion about the positive relationship between firm value and leverage not observed in the real world?

did not consider bankruptcy costs

Which costs of financial distress are easier to measure?

direct

Which two are broad types of costs of financial distress?

direct and indirect costs

Stockholders are paid __________ while bondholders are paid interest.

dividends

The optimal level of debt in the presence of corporate taxes and bankruptcy costs occurs at the point at which the PV of distress costs _________ the present value of tax shield benefits.

equals

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

equity; debt

The pmt to lawyers become relevant in the context of cap structure decisions in the event of __________.

financial distress

The WACC rises at higher levels of debt owing to:

financial distress costs

Marketed claims can be bought and sold in _____________.

financial mkts

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

firm value = value of equity + value of debt

Who is likely to have the most info about a firm's future prospects?

firm's manager

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

firms with high equity ownership tend to have lower leverage

As __________ CF 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

Financial slack helps firms avoid _____________.

having to rely on external funding

What is likely to impact on the work ethic of an employee once he acquires shares in the firm?

he will work harder

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

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

higher target debt-equity ratios

In a leveraged buyout (LB), current SH are bought out at a price that is __________.

higher than current mkt price

In presence of corp taxes, the tax shield effect of debt will _____ the value of the firm.

increase

The value of a firm will __________ when the firm first uses leverage if we assume there are no bankruptcy costs.

increase

Many real-world companies base their cap structure decisions on ___________.

industry averages

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

it lowers interest rate on the bonds

Trade-off theory implies that there is an optimal level of debt, but the pecking-order theory suggests that each firm chooses its leverage based on __________.

its financing needs

The optimal amount of debt is likely to be _______ in a world with personal taxes than in a world without them.

lower

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

manager bears only small fraction of costs but enjoys all benefits

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

max. tax shield benefit and min. financial distress costs

Mgt strives to __________ the value of marketed claims.

maximize

What is the danger of having too much financial slack?

may lead to wasteful investments or expeditures by maangers

What is mgt's attitude towards non-marketed claims?

mgt tries to reduce value of nonmarketed claims

Utilities industry is likely to use more debt because operating income tends to be ______.

more stable

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

no upper limit

In order to understand the effect of taxes on capital structure decisions, we need to consider both corporate and __________ taxes.

personal

Example of "milking the property"?

pmt of excessive divds to SH during financial distress

An increase in level of debt 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

Which firm has a higher debt capacity?

profitable firm

A __________ covenant is an agreement between BH and SH.

protective

Bond with __________ will be issued at a relatively low interest rate.

protective covenants

Agency costs __________ the value of a leveraged firm.

reduce

Cash dividends always __________ free cash flow.

reduce

Benefit of BH owning shares during financial distress:

reduces conflict between BH and SH

Increases the value of stocks and bonds:

reduction in govt taxes and claims of lawyers

Why do firms prefer not to issue equity?

share prices tend to drop when equity is issued

When will the firm be indifferent between issuing debt and equity?

when CF to BH equals CF to SH

Covenant types that can prevent the transfer of corporate assets to SH?

- restrictions on the sale of assets -divd. restrictions

Empirical data suggests what about the mkt's reaction to exchange offer announcements that increase leverage?

- stock prices rise substantially on the date of the announc.

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

- surveillance - proper reporting

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

- the prob. and expected costs of fin. distress will increase if debt rises above the optimal level - when the market discovers the truth, share prices will drop

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

shareholders have limited liability and are not personally responsible for the debt of the firm

In a financially distressed firm with SH and BH, who are likely winners and losers if the firm invests in risky projects during a recession?

shareholders win and bondholders lose

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 acct?

she brings in an addt partner and reduces her ownership share

Which theory of capital structure leads to a target debt ratio?

static trade-off theory of capital structure

Highly profitable firms are less 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

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

the firm loses the valuable tax shield benefits of debt

How does the existence of debt reduce free CFs?

the firm's obligation to make interest pmts reduces free CF

Optimal level of debt?

the level of debt at which the marginal tax benefit of debt equals the marginal distress costs of debt

Why are managers likely to work harder after an LBO?

the managers have greater ownership interest

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

there is a higher probability of experiencing financial distress