MBA 621
In an agency problem known as asset substitution, the agency cost is paid by: 1) the debt holders, since if the risky project is not successful debt holders will lose all their money. 2) the debt holders, since if the risky project is successful debt holders will receive less money. 3) the equity holders, since the strategy has a negative expected payoff. 4) the equity holders, since they will lose all their money whether or not the project is successful.
1
Which of the following statements is FALSE? 1)Although indirect costs of bankruptcy are difficult to measure accurately, they are typically much smaller than the direct costs of bankruptcy. 2)Bankruptcy protection can be used by management to delay the liquidation of a firm that should be shut down. 3)Because many aspects of the bankruptcy process are independent of the size of the firm, the costs are typically higher, in percentage terms, for smaller firms. 4)Aside from the direct legal and administrative costs of bankruptcy, many other indirect costs are associated with financial distress (whether or not the firm has formally filed for bankruptcy).
1
Which of the following statements is FALSE? 1)The Law of One Price implies that leverage will affect the total value of the firm under perfect capital market conditions. 2)In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firm's security holders is equal to the total cash flow generated by the firm's assets. 3)With perfect capital markets, leverage merely changes the allocation of cash flows between debt and equity, without altering the total cash flows of the firm. 4)In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.
1
Which of the following statements is FALSE? 1)The data show a clear preference for equity as a source of external financing for the total population of U.S. firms. 2)Debt as a fraction of firm value has varied in a range from 30-45% for the average firm. 3)Capital expenditures greatly exceed firms' external financing, implying that most investment and growth is supported by internally generated funds, such as retained earnings. 4)Firms in growth industries like biotechnology or high technology carry very little debt, whereas airlines, auto makers, utilities, and financial firms have high leverage ratios.
1
Which of the following statements is FALSE? 1)The tradeoff theory weighs the costs of debt that result from shielding cash flows from taxes against the benefits from the effects of financial distress associated with leverage. 2)Leverage has costs as well as benefits. 3)According to the tradeoff theory, the total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs. 4) Firms have an incentive to increase leverage to exploit the tax benefits of debt. But with too much debt, they are more likely to risk default and incur financial distress costs.
1
Which of the following statements is FALSE? 1)When a firm faces financial distress, creditors can gain by making sufficiently risky investments, even if they have negative NPV. 2)When a firm has leverage, a conflict of interest exists if investment decisions have different consequences for the value of equity and the value of debt. 3)In some circumstances, managers may take actions that benefit shareholders but harm the firm's creditors and lower the total value of the firm. 4)Agency costs are costs that arise when there are conflicts of interest between stakeholders.
1
Which of the following statements is FALSE? 1)Whether paid by the firm or its creditors, the indirect costs of bankruptcy increase the value of the assets that the firm's investors will ultimately receive. 2)In addition to the money spent by the firm, the creditors may incur costs during the bankruptcy process. 3)The bankruptcy code is designed to provide an orderly process for settling a firm's debts. 4)To ensure that their rights and interests are respected, and to assist in valuing their claims in a proposed reorganization, creditors may seek separate legal representation and professional advice.
1
Which of the following statements is FALSE? 1)An important consequence of leverage is the risk of bankruptcy. 2)Whether default occurs depends on the cash flows, not on the relative values of the firm's assets and liabilities. 3)Economic distress is a significant decline in the value of a firm's assets, whether or not it experiences financial distress due to leverage. 4)Modigliani and Miller's results continue to hold in a perfect market even when debt is risky and the firm may default.
2
Which of the following statements is FALSE? 1)Given a forecast of future interest payments, we can determine the interest tax shield and compute its present value by discounting it at a rate that corresponds to its risk. 2)The total value of the unlevered firm exceeds the value of the firm with leverage due to the present value of the tax savings from debt. 3)To compute the increase in the firm's total value associated with the interest tax shield, we need to forecast a firm's debt and its interest payments. 4)There is an important tax advantage to the use of debt financing.
2
Which of the following statements is FALSE? 1)With no debt, the WACC is equal to the unlevered equity cost of capital. 2)With perfect capital markets, a firm's WACC is dependent of its capital structure and is equal to its equity cost of capital only the firm it is unlevered. 3)As the firm borrows at the low cost of capital for debt, its equity cost of capital rises, but the net effect is that the firm's WACC is unchanged. 4)Although debt has a lower cost of capital than equity, leverage does not lower a firm's WACC.
2
Which of the following statements is TRUE? 1)According to the provisions of the 1978 Bankruptcy Reform Act, U.S. firms can file for two forms of bankruptcy protection: Chapter 11 or Chapter 13. 2)The Chapter 11 reorganization plan specifies the treatment of each creditor of the firm. In addition to cash payment, creditors may receive new debt or equity securities of the firm. The value of cash and securities is generally less than the amount each creditor is owed, but more than the creditors would receive if the firm were shut down immediately and liquidated. 3)In the Chapter 7 bankruptcy, all pending collection attempts are automatically suspended, and the firm's existing management is given the opportunity to propose a reorganization plan. 4)While developing a Chapter 11 reorganization plan, management ceases to operate the business.
2
Which of the following statements is TRUE? 1)The agency costs of debt can arise only if there is no chance the firm will default and impose losses on its debt holders. 2)Agency costs represent another cost of increasing the firm's leverage that will affect the firm's optimal capital structure choice. 3)An over-investment problem occurs when shareholders choose to not invest in a positive-NPV project. 4)When a firm faces financial distress, there will be no conflict of interest between shareholders and debtholders.
2
Which of the following statements is/are TRUE? I) When a firm fails to make a required payment to debt holders, it is in bankruptcy. II) With perfect capital markets, the risk of bankruptcy is not a disadvantage of debt-bankruptcy simply shifts the ownership of the firm from equity holders to debt holders without changing the total value available to all investors. III) Bankruptcy is a long and complicated process that imposes both direct and indirect costs on the firm and its investors that the assumption of perfect capital markets ignores. IV) Bankruptcy is rarely simple and straightforward-equity holders don't just "hand the keys" to debt holders the moment the firm defaults on a debt payment.
2, 3, & 4
Which of the following statements is/are TRUE? I) Firms with high R&D costs and future growth opportunities typically maintain high debt levels. II) The tradeoff theory explains how firms should choose their capital structures to maximize value to current shareholders. III) With tangible assets, the financial distress costs of leverage are likely to be low, as the assets can be liquidated for close to their full value. IV) Proponents of the management entrenchment theory of capital structure believe that managers choose a capital structure to avoid the discipline of debt and maintain their own job security.
2, 3, & 4 only
Which of the following is one unintended consequence of the federal bailouts in response to the 2008 financial crisis? 1) Bondholders will charge equity holders for the risk of this abuse. 2) Equity holders will credibly commit not to take excessive risk by agreeing to very strong bond covenants. 3) Lenders to corporations considered "too big to fail" may presume they have an implicit government guarantee, thus lowering their incentives to insist on strong covenants. 4) Managers who earned large bonuses when their businesses did well did not need to repay those bonuses later when things turned sour.
3
Which of the following statements is FALSE? 1) Leverage can reduce the degree of managerial entrenchment because managers are more likely to be fired when a firm faces financial distress. 2) When a firm is highly levered, creditors themselves will closely monitor the actions of managers, providing an additional layer of management oversight. 3) According to the empire building hypothesis, leverage increases firm value because it commits the firm to making future interest payments, thereby reducing excess cash flows and wasteful investment by managers. 4) Managers of large firms tend to earn higher salaries, and they may also have more prestige and garner greater publicity than managers of small firms. As a result, managers may expand (or fail to shut down) unprofitable divisions, pay too much for acquisitions, make unnecessary capital expenditures, or hire unnecessary employees.
3
Which of the following statements is FALSE? 1)Firms with steady, reliable cash flows, such as utility companies, are able to use high levels of debt and still have a very low probability of default. 2)If there were no costs of financial distress, the value of the firm would continue to increase with increasing debt until the interest on the debt exceeds the firm's earnings before interest and taxes and the tax shield is exhausted. 3)The costs of financial distress reduce the value of the levered firm, VL. The amount of the reduction decreases with the probability of default, which in turn increases with the level of the debt D. 4)The tradeoff theory states that firms should increase their leverage until it reaches the level D* for which VL is maximized.
3
Which of the following statements is FALSE? I)To determine the benefit of leverage for the value of the firm, we must compute the present value of the stream of future interest tax shields the firm will receive. 2)Because the cash flows of the levered firm are equal to the sum of the cash flows from the unlevered firm plus the interest tax shield, by the Law of One Price the same must be true for the present values of these cash flows. 3)By increasing the amount paid to debt holders through interest payments, the amount of the pre-tax cash flows that must be paid as taxes increases. 4)When a firm uses debt, the interest tax shield provides a corporate tax benefit each year.
3
Which of the following statements is TRUE? 1)Real estate firms are likely to have high costs of financial distress, as much of their value derives from assets that can be sold relatively easily. 2)At high levels of debt, the risk of default remains low and the main effect of an increase in leverage is an increase in the interest tax shield, which has present value t*D, where t* is the effective tax advantage of debt. 3)Firms whose value and cash flows are very volatile (for example, semiconductor firms) must have much lower levels of debt to avoid a significant risk of default. 4)The probability of financial distress does not depend on the likelihood that a firm will be unable to meet its debt commitments and therefore default.
3
Which of the following statements is FALSE? 1)Modigliani and Miller's conclusion verified the common view, which stated that even with perfect capital markets, leverage would affect a firm's value. 2)We can evaluate the relationship between risk and return more formally by computing the sensitivity of each security's return to the systematic risk of the economy. 3)Investors in levered equity require a higher expected return to compensate for its increased risk. 4)Leverage increases the risk of equity even when there is no risk that the firm will default.
4
Which of the following statements is/are TRUE? I) In general, the gain to investors from the tax deductibility of interest payments is referred to as the interest tax shield. II) The interest tax shield is the additional amount that a firm would have paid in taxes if it did not have leverage. II) Because Corporations pay taxes on their profits after interest payments are deducted, interest expenses reduce the amount of corporate tax firms must pay.
All of the above
Which of the following is NOT a direct cost of bankruptcy? Costs to creditors Investment banking costs Costs of accounting experts Legal costs and fees
Costs to creditors
Which of the following statements is/are FALSE? I) Leverage decreases the risk of the equity of a firm. II) Because the cash flows of the debt and equity sum to the cash flows of the project, by the Law of One Price the combined values of debt and equity must be equal to the cash flows of the project. III) Franco Modigliani and Merton Miller argued that with perfect capital markets, the total value of a firm depends on its capital structure.
I & III only
Which of the following is NOT one of Modigliani and Miller's set of conditions referred to as perfect capital markets? I) All investors hold the market portfolio. II) There are no taxes, transaction costs, or issuance costs associated with security trading. III) A firm's financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them. IV) Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.
I only
Which of the following statements is/are FALSE? I) While firms seem to prefer debt when raising external funds, not all investment is externally funded. II) To receive the full tax benefits of leverage a firm needs to use 100% debt financing. III) If bankruptcy is costly, these costs will increase the tax advantages of debt financing.
II & III only
A type of agency problem that results in shareholders gaining by choosing not to finance new, positive-NPV projects is: asset substitution. debt overhang. excessive risk-taking. distress costs.
debt overhang