Chapter 15. Capital Structure: Limits to the Use of Debt

Which one of the following 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 is correct concerning a Chapter 7 bankruptcy?

A trustee will assume control of the firm's assets until those assets can be liquidated.

Which one of the following statements concerning bankruptcy is correct?

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

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

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

Which one of the following describes a bankruptcy situation known as a "cram down"?

Creditors are forced to accept a bankruptcy plan that they voted to reject.

A firm may file for Chapter 11 bankruptcy: I. in an attempt to gain a competitive advantage. II. using a prepack. III. while allowing the current management to continue running the firm. IV. even though it is not insolvent.

I, II, III, and IV

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 the following 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 the following is true?

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

Which one of the following 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

Which one of the following is a payment of a nonmarketed claim on a firm's cash flows?

Payment of a customer's liability claim

Which one of the following best describes the relationship between bondholders and stockholders at a time when it appears the firm may be facing increased financial distress?

Stockholders have an incentive to underinvest in new projects to the detriment of bondholders.

Which one of the following statements most applies to a firm that is suffering from financial distress?

Stockholders ultimately bear the cost of selfish investment strategies.

Which one of the following statements is correct for a levered firm?

The optimal level of debt for a firm results in the value of that firm being maximized.

Which one of the following relationships will exist if a firm is operating under its optimal capital structure?

The present value of the financial distress costs will equal the present value of the tax shield on debt

Which one of the following statements is correct?

The value of a firm's marketed claims can change with changes in the firm's capital structure.

Which one of the following claims on a firm would be paid first in a bankruptcy liquidation if the court adheres to the absolute priority rule?

Wages, salaries, and commissions

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

a lower probability of financial distress.

Conflicts of interest between stockholders and bondholders are known as:

agency costs.

In an attempt to avoid bankruptcy, a firm may:

agree to a composition with its creditors.

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.

In a world with corporate taxes, MM theory implies that that all firms should:

choose an all-debt capital structure.

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:

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 optimal debt-equity ratio tends to:

increase when agency costs of equity exist.

The free cash flow hypothesis supports:

increasing the debt portion of a firm's capital structure to increase firm value.

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

indirect bankruptcy

A valuable firm will tend to:

issue more debt than a less valuable firm of comparable size.

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 concern is called a:

liquidation

The optimal capital structure of a firm __________ the marketed claims and __________ the nonmarketed claims against the cash flows of the firm.

maximizes; minimizes

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

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

Issuing new debt instead of new equity in a closely held firm more likely causes owner-managers to:

work harder than they would if equity had been issued.