Chapter 18 FIN 303

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Which of the following games do shareholders play when firms are in financial distress?

1. risk-shifting

Suppose that a firm that is all equity financed is valued at $300 million. The present value of its tax shield is $30 million. According to the principles of MM, what is the value of the firm?

300m + 30m = 330 Million

Suppose that a firm that is all equity financed is valued at $400 million. The present value of its tax shield is $30 million. According to the principles of MM, what is the value of the firm?

430 Million

The costs of financial distress depend mostly on how easily the ownership of the firm's ________ can be transferred.

Assets

Which costs of financial distress are easier to measure?

Direct Costs

True or false: According to M&M Proposition I, a firm's capital structure determines its value.

False

True or false: It is easy to measure indirect costs of financial distress.

False Reason: While the existence of indirect costs is recognized, these costs are not easy to measure.

Customers refusing to buy cars after GM filed for Chapter 11 (fearing the inability to service them in the future) is an example of ______ costs of financial distress.

Indirect

Which two of the following are broad types of costs of financial distress?

Indirect costs Direct costs

What is financial slack?

It is excess cash accumulated by the firm.

What is generally the most important component of direct costs in the case of bankruptcy?

Legal Costs

Stockholders of an unlimited liability firm lose __________ stockholders of a limited liability firm in bankruptcy.

More than

The costs of financial distress depend on which of the following:

Reason: The costs of financial distress depend on the probability of distress and the magnitude of costs if distress occurs

Which of the following is likely to be true when a bankruptcy ruling is issued?

The ownership of assets is transferred from the shareholders to the bondholders.

What do the academic studies conclude about the magnitude of direct costs of bankruptcy?

They are insignificant as a percentage of firm value.

Which of the following theories explains how much firms borrow?

Trade-off theory Pecking Order theory

True or false: In the case of a firm whose debt exceeds market value, a longer bond maturity means the firm has more time to try to generate profits to pay bondholders.

True

The relative tax advantage of debt when the corporate tax rate = 21%; and the personal tax rate on equity income = 20%; and the personal tax rate on interest income = 35% is _____________.

Very confused for this answer I think the key is wrong.

Which of the following games do shareholders play when firms are in financial distress?

cash in and run risk-shifting playing for time bait and switch

Financial distress occurs when promises to _________ are broken or honored with difficulty.

creditors

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:

debt

If a firm issues ______, shareholders will assume the firm's common stock is undervalued, but if a firm issues ______, shareholders will assume the firm's common stock is overvalued.

debt; equity

According to M&M Proposition I, a firm's capital structure choices:

do not affect the value of the firm

Stockholder of levered firms gain when business risk _________.

increases

According to the pecking order theory, where does a firm look to first for financing?

internal funds

Which of the following is the correct order of financing supporting the pecking order theory?

internal funds, new issues of debt, new issues of equity

Risk shifting occurs when a firm facing bankruptcy:

invests in high-risk, high-return projects

In practice, which of the following describes a firm with a high debt ratio?

large, mostly tangible assets, less profitable, lower market to book ratio

Bondholders protect themselves by placing which provisions in debt contracts?

limiting dividends restricting asset sales limiting more borrowing

What are some examples of indirect financial distress costs?

lost sales lost reputation

In practice, a firm with a low debt ratio will have which of the following characteristics?

low ratio of tangible to total assets highly profitable Reason: higher market to book ratio Reason: smaller in size

One of the indirect costs to bankruptcy is the incentive for shareholders turning down ___________ but positive NPV projects

low-risk, low-return

The costs of financial distress depend on which of the following:

magnitude of costs if distress occurs probability of distress

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:

only after internal funds are exhausted

Financial slack helps firms avoid ___.

relying on external financing

One of the indirect costs to bankruptcy is the incentive for ___________ turning down low-risk, low-return but positive NPV projects

shareholders

Debt contracts protect bondholders against:

stockholders' interests other bondholders' interests

In the case of a firm whose debt exceeds market value, a longer bond maturity means that:

the firm has more time to try to generate profits to pay bondholders

One important benefit of debt financing for corporations is:

the interest it pays on debt is tax-deductible

The ____ theory is the dominant theory of capital structure.

trade-off


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