Chapter 17
The direct costs of Enron's bankruptcy were estimated to be Blank______. Multiple choice question. $10 million $1 billion $245 million $2.2 billion
$1 billion
Andrade and Kaplan estimate total distress costs to be between Blank______. Multiple choice question. 1 and 5 percent of firm value 10 and 20 percent of firm value 25 and 35 percent of firm value 36 and 49 percent of firm value
10 and 20 percent of firm value
What is the optimal level of debt in a world with corporate taxes and no financial distress costs? Multiple choice question. Zero percent debt 25 percent debt 75 percent debt 100 percent debt
100 percent debt
the direct costs of Lehman Brother's bankruptcy were estimated to exceed Blank______. Multiple choice question. $1 billion $600 billion $2.2 billion $600 million
2.2 billion
Which of the following are consequences of nonpayment of debt obligations? Multiple select question. A firm may be forced to file for bankruptcy. Debt obligations will be repaid by the FDIC. A firm may be taken over by the local government. The firm will encounter some form of financial distress.
A firm may be forced to file for bankruptcy. The firm will encounter some form of financial distress.
Given agency conflicts between shareholders and bondholders, which type of firm is likely to experience distortions in an investment policy? Multiple choice question. A levered firm An unlevered firm
A levered firm
Which of the following are examples of signaling by a firm? Multiple select question. An increase in regulations An increase in corporate tax rates An increase in dividends An increase in the target debt ratio
An increase in dividends An increase in the target debt ratio
What is signaling? Multiple choice question. The list of warnings issued by auditors after a review of the annual financial statements. Communication by the firm to the board before it places a formal offer to acquire a rival firm. Any announcement or action by the firm that conveys information to the market. Stock option plans are designed to reward future performance.
Any announcement or action by the firm that conveys information to the market.
here is a precise mathematical equation that can be used to find the optimal debt-equity ratio for every firm. True false question. True False
False
How does managerial ownership of equity affect the debt-equity ratio of real world companies? Multiple choice question. Firms in which managers have low equity ownership tend to have no leverage. Firms in which managers have high equity ownership tend to have higher leverage. Firms in which managers have low equity ownership tend to have lower leverage. Firms in which managers have high equity ownership tend to have lower leverage.
Firms in which managers have high equity ownership tend to have lower leverage.
______ acquisitions tends to increase as free cash flow Blank______. Multiple select question. Bad; decrease Good; decrease Good; increase Bad; increase
Good; decrease Bad; increase
What is the likely impact on the work ethic of an employee once he acquires shares in the firm where he works? Multiple choice question. Employees cannot legally own shares. He is likely to work harder. He is likely to work less. His work behavior is unlikely to be affected by share ownership.
He is likely to work harder.
Why do bond covenants restrict high-risk investments by shareholders during financial distress? Multiple choice question. High-risk projects prevent the exercise of call rights by bondholders. High-risk projects restrict the conversion of convertible bonds. High-risk projects tend to transfer wealth from the shareholders to the bondholders. High-risk projects tend to transfer wealth from the bondholders to the shareholders.
High-risk projects tend to transfer wealth from the bondholders to the shareholders.
When is a rational firm likely to increase the level of debt so as to capture the tax shield benefit of debt? Multiple choice question. If losses are expected to be low. If losses are expected to be high. If profits are expected to be high. If profits are expected to be low.
If profits are expected to be high.
What are the advantages of using internal financing? Multiple select question. It prevents the adverse market reaction that tends to accompany a stock issue. It may be cheaper than debt or equity issues. The use of internal financing increases free cash flow. Firms are required to use internal financing before exploring external sources
It prevents the adverse market reaction that tends to accompany a stock issue. It may be cheaper than debt or equity issues.
What is the most important benefit of debt? Multiple choice question. It increases taxes. It lowers financial distress costs. It provides a tax benefit. It reduces the probability of bankruptcy.
It provides a tax benefit.
Why do firms prefer not to issue equity? Multiple choice question. New equity increases the liability for dividend payments. Share prices tend to drop when equity is issued. New equity increases the probability of bankruptcy. Share prices tend to rise when equity is issued.
Share prices tend to drop when equity is issued.
When bondholders own shares, it reduces the conflict between them and____
Shareholders
Who ultimately pays for the selfish strategies pursued by shareholders? Multiple choice question. The public Shareholders Bondholders The SEC
Shareholders
What does the empirical data suggest about the market's reaction to exchange offer announcements that increase leverage? Multiple choice question. Stock prices fall significantly on the date of the announcement. Stock prices do not react to the announcement. Stock prices rise substantially on the date of the announcement.
Stock prices rise substantially on the date of the announcement.
In a world without bankruptcy costs or taxes, the value of the firm (the pie) is divided among which of the following? Multiple select question. Stockholders Lawyers Bondholders The government
Stockholders Bondholders
Who are the main claimants of a firm's cash flows? Multiple select question. Board of directors Bondholders Stockholders Government
Stockholders Bondholders Government
True or false: Nonpayment of periodic interest on debt can lead to bankruptcy. True false question. True False
True
A negative covenant restricts the actions of the Blank______. Multiple choice question. exchanges company courts
company
The value of a levered firm is higher than the value of an unlevered firm in the presence of corporate taxes owing to the tax shield benefit of Blank______. Multiple choice question. dividends flotation costs debt depreciation
debt
Financial _______costs lower the value of the levered firm.
distress
U.S. firms Blank______ use enough debt to capture all the tax shield benefits of debt. Multiple choice question. do do not
do not
The empirical evidence on median debt-to-value ratios for countries around the world indicates that real-world companies Blank______. Multiple choice question. do not issue enough debt to significantly reduce or eliminate corporate taxes issue enough debt to significantly reduce or eliminate corporate taxes issue way too much debt
do not issue enough debt to significantly reduce or eliminate corporate taxes
When a firm issues equity, its share price tends to Blank______. Multiple choice question. drop remain the same increase
drop
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 Blank______ the present value of the tax shield benefits. Multiple choice question. minimizes maximizes equals
equals
No exact formula exists to evaluate the optimal debt-_____ratio.
equity
The free cash flow hypothesis suggests that a shift from Blank______ to Blank______ will boost firm value. Multiple choice question. debt; equity equity; debt
equity; debt
An ________offer allows bondholders to exchange some of their debt for stock.
exchange
The debt tax shield increases the value of the Blank______ firm. Multiple choice question. zero-debt simple levered tax
levered
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 Blank______. Multiple choice question. first and foremost only after the external equity capacity of the firm is exhausted on an equal basis with external equity only after internal funds are exhausted
only after internal funds are exhausted
Blank______ covenant specifies actions that the firm agrees to take. Multiple choice question. prescriptive preventive negative positive
positive
Modigliani and Miller suggest that there is a(n) Blank______ relationship between leverage and firm value in the presence of corporate taxes. Multiple choice question. neutral positive negative inverse
positive
A Blank______ covenant is an agreement between bondholders and stockholders. Multiple choice question. indentured protective ceremonial fictional
protective
Cash dividends always Blank______ free cash flow. Multiple choice question. eliminate escalate increase reduce
reduce
Financial distress costs will Blank______ the value of the firm. Multiple choice question. increase reduce enhance muddy
reduce
Increased monitoring will Blank______ agency costs. Multiple choice question. reduce increase
reduce
Protective covenants should Blank______ the costs of bankruptcy. Multiple choice question. eliminate reduce increase
reduce
The value of the firm is Blank______ by the agency costs of equity. Multiple choice question. increased reduced stabilized
reduced
The tendency to work less because of the incentive structure is called ______behavior.
shirking
Academic studies find that direct costs of financial distress are Blank______ as a percentage of firm value. Multiple choice question. small large
small
Highly profitable firms are likely to have higher debt ratios because they can deduct interest for Blank______ purposes. Multiple choice question. egregious investment tax internal
tax
A manager can benefit from pursuing negative NPV projects because Blank______. Multiple choice question. such activity will have a favorable impact on share prices the increase in firm size will likely lead to an increase in salary for the manager it will generate favorable tax benefits shareholders will reward managers for taking negative NPV projects
the increase in firm size will likely lead to an increase in salary for the manager
Most nonfinancial companies issue Blank______ debt. Multiple choice question. too much no too little
too little
If a firm issues debt, shareholders will assume the firm's common stock is Blank______, and/but if a firm issues equity, shareholders will assume the firm's common stock is Blank______. Multiple choice question. undervalued; overvalued undervalued; undervalued overvalued; undervalued overvalued; overvalued
undervalued; overvalued
Which type of firm is more susceptible to selfish shareholder strategies? Multiple choice question. A levered firm facing financial distress A financially healthy firm An all-equity firm A firm not listed on a stock exchange
A levered firm facing financial distress
Who is more likely to indulge in wasteful behavior? Multiple choice question. A manager with a large ownership interest in the firm A manager with a small ownership interest in the firm
A manager with a small ownership interest in the firm
Which firm has a higher debt capacity? Multiple choice question. A profitable firm An unprofitable firm
A profitable firm
Which of the following will increase the value of stocks and bonds? Multiple select question. An increase in the claims of lawyers A reduction in the claims of lawyers A reduction in government taxes An increase in government taxes
A reduction in government taxes A reduction in the claims of lawyers
What theoretical assumptions will lead to all-debt financing by firms? Multiple choice question. A world with no corporate taxes and no financial distress costs. A world with corporate taxes and financial distress costs A world with corporate taxes but no financial distress costs.
A world with corporate taxes but no financial distress costs.
Which of the following are examples of covenants in loan contracts? Multiple select question. Dividend limitations Limits on the sale of assets Maintenance of minimum working capital The imposition of unlimited liability on shareholders
Limits on the sale of assets Maintenance of minimum working capital Dividend limitations
What are some examples of indirect financial distress costs? Multiple select question. Lost dividends Legal expenses Lost reputation Lost sales
Lost reputation Lost sales
Which of the following factors affect the establishment of a target debt-equity ratio? Multiple select question. Taxes Uncertainty of operating income Advertising budget forecasts Type of assets, tangible or intangible
Taxes Uncertainty of operating income Type of assets, tangible or intangible
How does the level of debt affect the weighted average cost of capital (WACC)? Multiple choice question. The WACC initially rises and then falls as debt increases. The WACC initially falls and then rises as debt increases. The WACC always increases as debt increases. The WACC always falls as debt increases.
The WACC initially falls and then rises as debt increases.
How do bankruptcy costs impact the distribution of firm value between shareholders and bondholders? Multiple choice question. There is less left for shareholders and bondholders. There is more left for shareholders and bondholders. There is no effect on bondholders but less is available for shareholders. There is no effect on bondholders and shareholders.
There is less left for shareholders and bondholders.
When a firm announces an increase in debt, investors typically view this as Blank______. Multiple choice question. unimportant positive negative
positive
______ exists when a firm's manager knows more about the firm's prospects than the typical investor does. Multiple choice question. Asymmetric information Symmetric information Asymmetric data Symmetrical symbiosis
Asymmetric information
When is the present value of distress costs likely to exceed the present value of the tax shield from debt? Multiple choice question. At high levels of equity Present value of distress costs cannot exceed the present value of tax shield benefits At high levels of debt At low levels of debt
At high levels of debt
What does the empirical data reveal about the relationship between access to free cash flow and bad acquisitions by the firm? Multiple choice question. Bad acquisitions tend to decrease as free cash flow increases. Bad acquisitions tend to generate more free cash flow for the firm. Bad acquisitions tend to increase as free cash flow increases. There is no relationship between bad acquisitions and access to free cash flows.
Bad acquisitions tend to increase as free cash flow increases.
What are some ways in which a bankruptcy filing might hinder a firm's normal business operations? Multiple select question. The government may increase taxes on future sales. Suppliers may not supply inventory, fearing nonpayment. Customers may not buy, fearing future service problems. Banks may place restrictions on the firm's financial activities.
Banks may place restrictions on the firm's financial activities. Customers may not buy, fearing future service problems. Suppliers may not supply inventory, fearing nonpayment.
From a tax shield perspective, why would a firm with low profits not borrow much? Multiple choice question. Because the firm needs a large interest deduction to offset the pretax profits. A firm with low profits will need special approval from shareholders to borrow large sums of money. Because the firm needs only a small interest deduction to offset pretax profits. A firm with low profits cannot legally borrow large sums of money.
Because the firm needs only a small interest deduction to offset pretax profits.
In the event of the liquidation of a firm, who gets paid first? Multiple choice question. Bondholders Shareholders
Bondholders
What are the two types of exchange offers? Multiple select question. A publicly traded firm can be converted into a privately held firm. Shareholders are allowed to exchange some of their stocks for debt. Bondholders are allowed to exchange some of their debt for stock. The bidding firm in a merger can obtain assets in exchange for cash or shares.
Bondholders are allowed to exchange some of their debt for stock. Shareholders are allowed to exchange some of their stocks for debt.
How do bankruptcy costs affect bondholders and shareholders in the context of the distribution of firm value? Multiple choice question. Only shareholders are adversely affected. Both bondholders and shareholders are adversely affected. Only bondholders are adversely affected. Neither bondholders nor shareholders are adversely affected.
Both bondholders and shareholders are adversely affected.
Under pecking order theory firms can choose between debt or equity for external financing, which will they prefer? Multiple choice question. Equity Debt
Debt
Why do firms prefer debt over equity as a source of external financing? Multiple select question. Debt has more risk than equity. Debt is less likely to be mispriced Debt is more likely to be mispriced Equity has more risk than debt.
Debt is less likely to be mispriced Equity has more risk than debt.
Which two of the following are broad types of costs of financial distress? Multiple select question. Reorganization costs Indirect costs Direct costs Liquidation costs
Direct costs Indirect costs
In bankruptcy cases, different groups of creditors unite as one group. True false question. True False
False
It is easy to measure the indirect costs of financial distress. True false question. True False
False
MM's assertion of a positive relationship between firm value and leverage is widely observed in the business world. True false question. True False
False
Protective covenants are classified as either direct or indirect covenants. True false question. True False
False
True or false: Corporate managers can consistently manipulate and fool the market. True false question. True False
False
True or false: There is a precise mathematical equation for determining the optimal level of debt for any firm. True false question. True False
False
True or false: Very few firms in the real world have target debt ratios. True false question. True False
False
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? Multiple select question. Increase his work-related perquisites Increase the number of hours he works each week Increase his leisure time Take on unprofitable projects
Increase his work-related perquisites Take on unprofitable projects Increase his leisure time
Why do profitable firms tend to have more debt? Multiple choice question. Interest payments can be converted to dividends. Interest expense increases taxable income. Principal payments increase risk. Interest expense generates tax savings.
Interest expense generates tax savings.
According to the free cash flow hypothesis, which has the greater potential to reduce wasteful spending? Multiple choice question. Interest on debt because interest payments tend to be higher than dividend payments. Interest on debt because interest is a legal obligation. Stock dividends because dividends are a legal obligation. Stock dividends because there is no upper limit on dividends.
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? Multiple choice question. Stock dividends because dividends are a legal obligation. Interest on debt because interest is a legal obligation. Stock dividends because there is no upper limit on dividends. Interest on debt because interest payments tend to be higher than dividend payments.
Interest on debt because interest is a legal obligation.
What are the benefits of having fewer lenders during bankruptcy? Multiple select question. It generates less scrutiny by the press. It makes it easier for the firm to negotiate with lenders. It increases the time spent in bankruptcy. It reduces the conflicts among lenders.
It reduces the conflicts among lenders. It makes it easier for the firm to negotiate with lenders.
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? Multiple choice question. Jackie sells off her assets to raise $200,000. Jackie borrows $200,000 and retains full ownership. Jackie uses her personal inheritance to raise the $200,000. Jackie brings in an additional partner and reduces her ownership share.
Jackie brings in an additional partner and reduces her ownership share.
What is generally the most important component of direct costs of financial distress? Multiple choice question. Penalties on leases Lost sales Unpaid taxes Legal costs
Legal costs
Why is MM's assertion about the positive relationship between firm value and leverage not observed in the real world? Multiple choice question. MM did not consider the debt tax shield. MM did not consider dividend costs. MM did not consider bankruptcy costs.
MM did not consider bankruptcy costs.
Based on the trade-off theory, what should the managers attempt to maximize and minimize while developing capital structure policy? Multiple choice question. Maximize debt and minimize equity. Maximize the tax shield benefit of debt and minimize financial distress costs. Minimize the tax shield benefit of debt and maximize financial distress costs. Maximize equity and minimize debt.
Maximize the tax shield benefit of debt and minimize financial distress costs
What type of covenants may restrict shareholders from pursuing high-risk investments during financial distress? Multiple select question. Minimum net worth restrictions Limits on managerial compensation The imposition of unlimited liability on shareholders Minimum interest coverage restrictions
Minimum net worth restrictions Minimum interest coverage restrictions
Which of the following entities can file for bankruptcy protection? Multiple select question. Partnerships Municipalities Corporations Federal government
Municipalities Partnerships Corporations
Given agency conflicts, why would shareholders tend to underinvest during times of financial distress? Multiple choice question. New investment benefits the shareholders at the bondholder's expense. Shareholders cannot legally invest if the firm is facing financial distress. New positive net present value investments cannot be found. New investment benefits the bondholders at the shareholder's expense.
New investment benefits the bondholders at the shareholder's expense
What are some ways to reduce the agency costs of equity? Multiple select question. Caps on bonuses of managers Limits on dividend payments Proper reporting Surveillance
Proper reporting Surveillance
According to the pecking order theory, what is the preferred source for firms seeking to raise capital? Multiple choice question. Retained earnings A debt issue The federal government An equity issue
Retained earnings
What is the preferred source of financing for firms according to the pecking-order theory? Multiple choice question. Common stock Debt Retained earnings Preferred stock
Retained earnings
___________ultimately bear the cost of selfish strategies pursued by shareholders.
Shareholders
How does the concept of limited liability apply to shareholders? Multiple choice question. Shareholders can be held personally liable for the debts of the corporation. Shareholders' liability is limited to losses not covered by the federal government. Shareholders cannot be held personally liable for the debts of the corporation. Shareholders' liability is limited to the total intangible assets of the corporation.
Shareholders cannot be held personally liable for the debts of the corporation.
In a financially distressed firm with shareholders and bondholders, who are the likely winners and losers if the firm invests in risky projects during a recession? Multiple choice question. Both shareholders and bondholders win Shareholders win and bondholders lose Bondholders win and shareholders lose Both shareholders and bondholders lose
Shareholders win and bondholders lose
Which of the following is true after an LBO? Multiple select question. The ownership pattern changes. The company is generally owned by more investors than it was previously. The firm is debt-free. The company is owned by a few investors.
The company is owned by a few investors. The ownership pattern changes.
Which of the following are examples of a positive covenant? Multiple select question. The firm must furnish financial statements every quarter. The firm must maintain a debt ratio of 50 percent. The firm must not invest in high-risk projects. The firm must not pay more than 30 percent of net income as dividends.
The firm must maintain a debt ratio of 50%. The firm must furnish financial statements every quarter.
How does the existence of debt reduce free cash flow? Multiple choice question. The firm's obligation to make interest payments reduces free cash flow. If a firm pays interest on debt, it is obliged to pay an equal amount in dividends. Debt does not reduce free cash flow.
The firm's obligation to make interest payments reduces free cash flow.
If a firm is in financial distress, who will get paid first? Multiple choice question. The bondholders and the lawyers have equal seniority The bondholders The shareholders The lawyers
The lawyers
Which of the following is likely to be true when a bankruptcy ruling is issued? Multiple choice question. The ownership of assets is transferred from the shareholders to the bondholders. There is no change in the ownership of assets. The ownership of assets is transferred from the bondholders to the shareholders. The ownership of assets is transferred from the shareholders to the federal government.
The ownership of assets is transferred from the shareholders to the bondholders.
What is the attitude of shareholders toward risky projects when the firm is in financial distress? Multiple choice question. The shareholders are indifferent towards the riskiness of the project. The shareholders prefer to invest in risky projects. The shareholders prefer to avoid investing in risky projects.
The shareholders prefer to invest in risky projects.
What are the two components of the trade-off theory? Multiple choice question. High equity and low equity The tax benefits of debt and the costs of financial distress High leverage and low leverage The tax benefits of financial distress and the cost of debt
The tax benefits of debt and the costs of financial distress
What is shirking behavior? Multiple choice question. The work done by bondholders on behalf of the shareholders. The work done by shareholders on behalf of the bondholders. The tendency to work more because of the incentive structure. The tendency to work less because of the incentive structure.
The tendency to work less because of the incentive structure.
What do Modigliani and Miller assert about the relationship between leverage and firm value in the presence of corporate taxes? Multiple choice question. The value of the firm increases with leverage. The value of the firm decreases with leverage. The value of the firm is not affected by leverage. The value of the firm is low at high levels of debt and high at low levels of debt.
The value of the firm increases with leverage.
What is the difference in the limits on the payments to shareholders and bondholders? Multiple choice question. There is no limit on the payments to shareholders; there is a fixed upper limit on the payments to bondholders. The payments to shareholders cannot be more than twice the quoted interest rate on bonds. There is no limit on the payments to bondholders; there is a fixed upper limit on the payments to shareholders. There is no difference in the limits on the payments to each group.
There is no limit on the payments to shareholders; there is a fixed upper limit on the payments to bondholders.
What is the upper limit on a payment to common stockholders? Multiple choice question. The payment cannot exceed the rate paid to bondholders. The payment cannot exceed the rate paid last year. The payment cannot exceed the rate paid to preferred stockholders. There is no upper limit.
There is no upper limit.
What is the expression for the value of a levered firm in the presence of corporate taxes? Multiple choice question. Value of Levered Firm = Value of Unlevered Firm + Tax Benefit of Debt Value of Levered Firm = Value of Unlevered Firm Value of Levered Firm = Value of Unlevered Firm − Tax Benefit of Debt Value of Levered Firm = Value of Unlevered Firm × Tax Benefit of Debt
Value of Levered Firm = Value of Unlevered Firm + Tax Benefit of Debt
What are some possible consequences of raising debt to fool the market about a firm's value? Multiple select question. When the market discovers the truth, share prices will increase. The probability and expected costs of financial distress will increase if debt rises above the optimal level. The probability and expected costs of financial distress will decrease if debt rises above the optimal level. When the market discovers the truth, share prices will drop.
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.
A stock price fall may come from Blank______. Multiple choice question. an increase in debt a decrease in debt
a decrease in debt
An example of an ________cost is when a firm issues more equity and an entrepreneur increases leisure time.
agency
The________ costs of equity reduces the value of the firm.
agency
If a manager has more information than an investor about the firm, that information is referred to as Blank______ information. Multiple choice question. irrational asymmetric typical public
asymmetric
During bankruptcy, the ownership of the firm's assets is transferred from stockholders to Blank______. Multiple choice question. federal agencies bondholders stakeholders equity holders
bondholders
During times of financial distress, the selfish actions of shareholders may lead to the expropriation of wealth from Blank______. Multiple choice question. customers bondholders regulators the government
bondholders
Capital structure Blank______ affect the value of marketable claims. Multiple choice question. can not can
can
Municipalities Blank______ file for bankruptcy. Multiple choice question. can can not
can
An increase in free ____flow tends to increase wasteful spending.
cash
the value of a firm is equal to the value of its Blank______. Multiple choice question. reputation current assets minus current liabilities debt plus equity retained earnings plus short-term debt
debt plus equity
Firm value initially increases when the proportion of debt in the capital structure increases due to the Blank______. Multiple choice question. lower dividend payments lower interest expenses debt tax shield higher dividend payments
debt tax shield
If a firm issues Blank______, shareholders will assume the firm's common stock is undervalued, but if a firm issues Blank______, shareholders will assume the firm's common stock is overvalued. Multiple choice question. dividends; stock debt; bonds debt; equity stock; debt
debt; equity
A broken covenant can lead to
default
Financial distress costs are Blank______ to quantify. Multiple choice question. simple easy difficult impossible
difficult
The value of the firm is given by the following expression Blank______. Multiple choice question. firm value = value of equity firm value = value of assets − value of debt firm value = value of equity + value of assets firm value = value of equity + value of debt
firm value = value of equity + value of debt
As Blank______ cash flow increases, wasteful activity in the firm tends to increase. Multiple choice question. free costly accounting
free
In bankruptcy cases, the claims of lawyers are Blank______ the claims of senior bondholders. Multiple choice question. only paid after considered equal to given priority over
given priority over
Nonmarketable claims include claims of the Blank______. Multiple select question. shareholders bondholders lawyers government
government lawyers
The optimal debt-equity ratio will be Blank______ in a world with agency costs of equity than in a world without these costs. Multiple choice question. higher lost invalid lower
higher
industries with Blank______ levels of investment in tangible assets are likely to have higher debt ratios. Multiple choice question. higher insignificant reduced lower
higher
Shareholders bear the costs of selfish strategies through Blank______. Multiple select question. higher interest rates on bonds increased difficulty in selling bonds to raise money higher dividend yields on stocks higher flotation costs
higher interest rates on bonds increased difficulty in selling bonds to raise money
In the real world, firms with high levels of investment in tangible assets will have Blank______. Multiple choice question. lower debt levels more legal problems higher target debt-equity ratios higher costs of financial distress
higher target debt-equity ratios
In a leveraged buyout (LBO), current shareholders are bought out at a price that is Blank______. Multiple choice question. lower than the current market price unfair to shareholders determined by a panel of economists higher than the current market price
higher than the current market price
In the presence of corporate taxes, the tax shield effect of debt will Blank______ the value of the firm. Multiple choice question. increase decrease initially decrease and then increase initially increase and then decrease
increase
The value of a firm will Blank______ when the firm first uses leverage if we assume that there are no bankruptcy costs. Multiple choice question. decrease gyrate increase plummet
increase
protective covenants are most apt to Blank______ the value of a firm. Multiple choice question. have no effect increase decrease
increase
Volatility in income Blank______ the probability of financial distress. Multiple choice question. has no impact on decreases increases
increases
As firm size Blank______, managerial salaries tend to Blank______. Multiple choice question. increases; increase decrease; increase increases; decrease
increases; increase
As debt Blank______, bankruptcy costs Blank______. Multiple select question. increases; increase increases; decrease decreases; increase deceases; decrease
increases; increase deceases; decrease
Protective covenants benefit shareholders by Blank______. Multiple select question. decreasing the dividend yield increasing firm value lowering interest rates on bonds eliminating call provision on bonds
increasing firm value lowering interest rates on bonds
Many real-world companies base their capital structure decisions on Blank______. Multiple choice question. industry averages federal guidelines proprietary mathematical equations
industry averages
When a firm is in financial distress, the shareholders have an incentive to Blank______. Multiple choice question. invest in safer projects avoid investing in risky projects invest in risky projects engage in activities that reduce risk
invest in risky projects
There Blank______ a danger to having too much financial slack. Multiple choice question. is not is
is
After an LBO, managers are likely to shirk Blank______. Multiple choice question. more less harder all duties
less
An individual will work Blank______ if they own a Blank______ percentage of the company. Multiple select question. less; larger harder; larger less; smaller harder; smaller
less; smaller harder; larger
Industries with high growth rates are likely to have Blank______ debt ratios. Multiple choice question. lower average higher erratic
lower
Protective covenants typically Blank______ interest rates. Multiple choice question. raise lower have no impact on
lower
bankruptcy costs are likely to be Blank______ if there are fewer groups of lenders. Multiple choice question. unchanged eliminated higher lower
lower
under the pecking-order theory, profitable firms will tend to have Blank______ levels of debt. Multiple choice question. higher extreme lower erratic
lower
In the real world, firms with high levels of investment in research and development will have Blank______. Multiple choice question. higher target debt-equity ratios higher costs of financial distress lower target debt-equity ratios more legal problems
lower target debt-equity ratios
Paying out an extra dividend during financial distress is an example of shareholders "_____ the property."
milking
Profitable firms will tend to have Blank______ debt than unprofitable firms. Multiple choice question. more less
more
The agency costs of equity makes debt financing Blank______ attractive. Multiple choice question. less more
more
Utilities tend to use Blank______ debt, relative to other industries. Multiple choice question. the same amount of more less
more
Compared to the pharmaceutical industry, the utilities industry is likely to use more debt because operating income tends to be Blank______. Multiple choice question. more stable more volatile less stable unpredictable
more stable
What are the two types of protective covenants? Multiple select question. Shareholder covenants Negative covenants Bondholder covenants Positive covenants
positive covenants negative covenants
In an agency relationship the Blank______. Multiple choice question. shareholders enter into a legal relationship with each other all legal issues have to be approved by a board appointed auditor agent principal delegates decision making authority to an agent agent delegates decision making authority to a principal
principal delegates decision making authority to an agent
One of the important reasons why firms choose to raise capital by issuing debt is because of the Blank______ benefits of debt. Multiple choice question. safety tax stabilizing
tax
Firms with volatile operating income tend to have lower debt ratios because Blank______. Multiple choice question. the need for external financing is higher there is a higher probability of experiencing financial distress the need for external financing is lower there is a lower probability of experiencing financial distress
there is a higher probability of experiencing financial distress
Which of the following are examples of perquisites? Multiple select question. A company car Use of a company jet Stock options A big office
use of a company jet a big office a company car
Investors react positively to an increase in a firm's level of debt because they expect the Blank______. Multiple select question. value of the firm to increase firm to pay more in taxes value of the firm to decrease firm to generate tax savings
value of the firm to increase firm to generate tax savings
What are some ways in which bondholders protect themselves from the selfish strategies of shareholders? Multiple select question. By changing shareholders' representatives on the board of directors By lending at higher interest rates By not lending or lending selectively By increasing the dividends to shareholders
By not lending or lending selectively By lending at higher interest rates
Which of the following is an example of "milking the property"? Multiple choice question. Leasing tangible assets Payment of additional interest to bondholders during financial distress Repaying bonds prior to their maturity date Payment of excessive dividends to shareholders during financial distress
Payment of excessive dividends to shareholders during financial distress
The payment to lawyers become relevant in the context of capital structure decisions in the event of Blank______. Multiple choice question. an early redemption of bonds a strike by company employees financial distress an all-equity firm
financial distress
The weighted average cost of capital rises at higher levels of debt owing to Blank______. Multiple choice question. higher working capital financial distress costs higher dividend costs excess free cash flow
financial distress costs
Legal costs are typically the most important component of _______costs.
direct
The two broad types of costs of financial distress are Blank______ costs. Multiple choice question. implied and inferred paid and unpaid direct and indirect potential and realized
direct and indirect
When raising debt to fool the market, the stock price will Blank______ when the market realizes the company tried to fool it. Multiple choice question. increase fall remain the same
fall
Financial slack helps firms avoid Blank______. Multiple choice question. having to rely on external financing free cash flow the misuse of funds having to rely on internal financing
having to rely on external financing
Due to financial distress, shareholders may invest in Blank______ risk projects, at the expense of bondholders. Multiple choice question. high low no
high
Firms in which managers have Blank______ equity ownership tend to have Blank______ leverage. Multiple select question. low; higher low; lower high; lower high; higher
high; lower low; higher
Industries with Blank______ levels of investment in tangible assets are likely to have higher debt ratios. Multiple choice question. lower insignificant reduced higher
higher
What is the consequence of breaking the bond covenant? Multiple choice question. Shareholders have to sell their shares to bondholders. All outstanding bonds are converted to common stocks. Outstanding bonds must be redeemed at the current market price. It can lead to default.
It can lead to default.
What is financial slack? Multiple choice question. It is the deficit in working capital requirements. It is excess cash accumulated by the firm. It is the difference between total equity and total debt. It is the deficit in long-term working capital requirements.
It is excess cash accumulated by the firm.
What is the danger of having too much financial slack? Multiple choice question. It may lead to wasteful investments or expenditures by managers. It may trigger an audit by the IRS. It may lead to excessive interest costs on debt. It may reduce the firm's credit rating.
It may lead to wasteful investments or expenditures by managers.
What is the benefit of bondholders owning shares during financial distress? Multiple choice question. It avoids formal bankruptcy filing. It increases the price of shares. It increases conflict between bondholders and shareholders. It reduces conflict between bondholders and shareholders.
It reduces conflict between bondholders and shareholders.
According to the free cash flow hypothesis, how does the distribution of dividends benefit shareholders? Multiple choice question. It reduces the amount of free cash flow available to managers for making bad acquisitions. It increases the amount of free cash flow available to managers for making bad acquisitions. It prevents the dilution of existing shareholders. Dividends are always the best use for free cash flows.
It reduces the amount of free cash flow available to managers for making bad acquisitions.
Which of the following are examples of investment policy distortion that can be caused by financial distress? Multiple select question. Shareholders may invest in only positive net present value (NPV) projects. Shareholders may pursue high-risk projects that could hurt bondholders. Shareholders may forego profitable projects if some of the benefits have to be shared with bondholders. Shareholders may require additional dividend payments.
Shareholders may pursue high-risk projects that could hurt bondholders. Shareholders may forego profitable projects if some of the benefits have to be shared with bondholders. Shareholders may require additional dividend payments.
What are shareholders liable for if the firm is in financial distress and can pay only 80 percent of the payment due to the bondholders? Multiple choice question. Since shareholders have limited liability, they are not personally responsible for the debt obligations of the firm. The shareholders will have to borrow to payoff the bondholders. The loss of 20 percent will be shared among the bondholders and the shareholders. The bondholders can sue and hold the shareholders responsible for the remaining 20 percent.
Since shareholders have limited liability, they are not personally responsible for the debt obligations of the firm.
How can the selfish stockholder strategy of taking more risk during periods of financial distress lead to agency costs? Multiple choice question. The shareholders may have to forego their annual dividend income. The bondholders may get paid less with a high-risk project relative to a low-risk project. The bondholders may get paid more with a high-risk project relative to a low-risk project. The bankruptcy court rules unfavorably on high-risk projects.
The bondholders may get paid less with a high-risk project relative to a low-risk project.
How can the selfish stockholder strategy of taking more risk during periods of financial distress lead to agency costs? Multiple choice question. The shareholders may have to forego their annual dividend income. The bondholders may get paid more with a high-risk project relative to a low-risk project. The bondholders may get paid less with a high-risk project relative to a low-risk project. The bankruptcy court rules unfavorably on high-risk projects.
The bondholders may get paid less with a high-risk project relative to a low-risk project.
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? Multiple select question. The project is risky. The shareholders will not invest because the project has a negative NPV. The bondholders would receive a $500 benefit at no cost to them. 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. The shareholders would invest $2,000 but receive only a $1,500 benefit.
Which of the following are examples of a negative covenant? Multiple select question. The firm is restricted from merging with another firm. The firm must maintain a current ratio at 1.5. The firm must hold a quarterly meeting with the auditors. The firm may not pay excessive dividends.
The firm is restricted from merging with another firm The firm may not pay excessive dividends
Why is a manager with a small ownership interest in the firm more likely to indulge in wasteful behavior? Multiple choice question. The manager with a small ownership interest has a longer tenure with the firm. The manager bears a large fraction of the costs but enjoys an insignificant portion of the benefits. The manager bears only a small fraction of the costs but enjoys all the benefits. The manager with a small ownership interest is not monitored by the firm.
The manager bears only a small fraction of the costs but enjoys all the benefits. Need help? Review these concept resources.
Why are managers likely to work harder after an LBO? Multiple choice question. The managers are more accountable to the shareholders after an LBO. The managers have borrowed from the firm. The managers have a greater ownership interest. The managers are legally required to work harder.
The managers have a greater ownership interest.
What is the upper limit on payments to bondholders by the corporation regardless of the level of profits? Multiple choice question. The obligation due in terms of interest and principal. The obligation due in terms of interest and principal plus a proportionate share of additional profits generated. The obligation due in terms of principal payment. The obligation due in terms of periodic interest payment.
The obligation due in terms of interest and principal
What are marketable claims? Multiple choice question. These are claims that cannot be bought and sold in the market. These are claims that can be bought and sold in the market. These are the exclusive claims of bondholders over shareholders. These are claims that are presented to the public through advertising.
These are claims that can be bought and sold in the market.
What do the academic studies conclude about the magnitude of direct costs of bankruptcy? Multiple choice question. They are significantly high as a percentage of firm value. They are equal to the indirect costs of bankruptcy. They exceed the value of the firm. They are insignificant as a percentage of firm value.
They are insignificant as a percentage of firm value.
What is the role of expert witnesses? Multiple choice question. They gather information to write about the bankruptcy case. They testify about the fairness of a proposed settlement. They testify about the incidence of fraud in financial statements. They testify against the claims of bondholders.
They testify about the fairness of a proposed settlement.
What is the benefit of writing protective and restrictive covenants into loan contracts? Multiple choice question. They will reduce the dividend yield. They will lower the interest rate on bonds. They will eliminate the dividend yield. They will increase the interest rate on bonds.
They will lower the interest rate on bonds.
Which theory implies a target level of debt? Multiple choice question. Capital structure Pecking order theory Trade-off theory
Trade-off theory
Expert witnesses are professionals that are used by the corporation and the bondholders to evaluate the fairness of the bankruptcy settlement. True false question. True False
True
It is possible for the present value of distress costs to exceed the present value of tax savings. True false question. True False
True
in 2019, the U.S. collected over $230 billion in corporate taxes. What do these figures suggest about the capital structure choices of U.S. firms? Multiple choice question. U.S. firms do not use enough debt to capture all the tax shield benefits of debt. U.S. firms maximize debt levels in order to capture the tax shield benefits of debt. U.S. firms do not use debt in their capital structure. U.S. firms do not use equity in their capital structures.
U.S. firms do not use enough debt to capture all the tax shield benefits of debt.
Different creditors fighting with each other Blank______ bankruptcy costs. Multiple choice question. decreases has no effect on increases
increases
According to survey evidence, a Blank______ of firms have target debt ratios. Multiple choice question. majority minority
majority
A rational manager will try to maximize the value of Blank______ claims and minimize the value of Blank______ claims. Multiple choice question. nonmarketed; marketed marketed; nonmarketed
marketed; nonmarketed
Managers will try to Blank______ the value of marketed claims. Multiple choice question. obfuscate eliminate minimize maximize
maximize
According to the static theory, the optimal level of debt Blank______ the WACC. Multiple choice question. equals maximizes minimizes
minimizes
Based on the free cash flow hypothesis, firms should issue Blank______ debt. Multiple choice question. more less no
more
