Financial Management Final Exam
Distinguish between a cash offer and a rights offer when selling stock in a seasoned equity offering: (Select all of the choices that apply.) A. A cash offer is used when a company offers the new shares to investors-at-large. B. A rights offer is used when the new shares are offered only to existing shareholders. C. A rights offer is used when a company offers the new shares to investors-at-large. D. A cash offer is used when the new shares are offered only to existing shareholders.
A. A cash offer is used when a company offers the new shares to investors-at-large. B. A rights offer is used when the new shares are offered only to existing shareholders.
Which of the following firms is likely to maintain low levels of debt? A. An Internet firm B. A tobacco company C. A mature restaurant chain D. An electric utility
A. An Internet firm
What are some of the alternative sources from which private companies can raise equity capital? Private companies can raise equity capital from: (Select all of the choices that apply.) A. Angel investors. B. Venture capitalists. C. Institutional investors. D. Bond investors. E. Corporate investors.
A. Angel investors. B. Venture capitalists. C. Institutional investors. E. Corporate investors.
Which of the following statements is FALSE? A. An "allocation trip" is where senior management and the lead underwriters travel around the country (and sometimes around the world) promoting the company and explaining their rationale for the offer price to the underwriters' largest customers—mainly institutional investors such as mutual funds and pension funds. B. Before the offer price is set, the underwriters work closely with the company to come up with a price range that they believe provides a reasonable valuation for the firm. C. Once the issue price (or offer price) is set, underwriters may invoke another mechanism to protect themselves against a loss—the over−allotment allocation. D. Before an IPO, the company prepares the final registration statement and final prospectus containing all the details of the IPO, including the number of shares offered and the offer price.
A. An "allocation trip" is where senior management and the lead underwriters travel around the country (and sometimes around the world) promoting the company and explaining their rationale for the offer price to the underwriters' largest customers—mainly institutional investors such as mutual funds and pension funds.
Which of the following statements is FALSE? A. As the debt level increases, the firm faces decreased incentives for management, which increase wasteful investment and perks. B. The optimal level of debt D* balances the costs and benefits of leverage. C. If the debt level is too large, firm value is reduced due to the loss of tax benefits (when interest exceeds EBIT), financial distress costs, and the agency costs of leverage. D. As the debt level increases, the firm benefits from the interest tax shield (which has present value τ*D).
A. As the debt level increases, the firm faces decreased incentives for management, which increase wasteful investment and perks.
Which of the following statements is FALSE? A. As with IPOs, evidence suggests that companies overperform following a seasoned offering. B. Often the value destroyed by the price decline can be a significant fraction of the new money raised with a SEO. C. The one advantage of a cash offer is that the underwriter takes on a larger role and, therefore, can credibly certify the issue's quality. D. SEO underwriting fees average about 5% of the proceeds of the issue and, as with IPOs, the variation across issues of different sizes is relatively small.
A. As with IPOs, evidence suggests that companies overperform following a seasoned offering.
Why is an announcement of a share repurchase considered a positive signal? (Select the best choice below.) A. By choosing to do a share repurchase, management credibly signals that it believes the stock is undervalued. B. Share repurchases increase demand for the stock. By the law of supply and demand, when demand increases, prices must rise, which is good news. C. Share repurchases reduce dilution, which is a good thing for investors. D. Share repurchases are a capital structure decision. According to Modigliani-Miller, financial policy should not matter; therefore, even when markets are not perfect, share repurchases should not affect value, hence they are neither a positive or negative signal.
A. By choosing to do a share repurchase, management credibly signals that it believes the stock is undervalued.
Under which conditions can an increase in the dividend payment be interpreted as a signal of good news: (Select the best choice below.) A. By increasing dividends managers signal that they believe that future earnings will be high enough to maintain the new dividend payment. B. By increasing dividends managers signal higher future growth prospects, which is good news. C. By increasing dividends managers signal that they have cash to pay out, which is good news. D. Raising dividends gives investors more cash, so the stock price increases, which is good news.
A. By increasing dividends managers signal that they believe that future earnings will be high enough to maintain the new dividend payment.
Which of the following is NOT a step in the valuation process using the flow to equity method? A. Determine the before−tax cost of capital, rU. B. Compute the equity value, E, by discounting the free cash flow to equity using the equity cost of capital. C. Determine the equity cost of capital, rE. D. Determine the free cash flow to equity of the investment.
A. Determine the before−tax cost of capital, rU.
Which of the following statements is FALSE? A. Most companies that pay dividends pay them semiannually. B. Occasionally, a firm may pay a one−time, special dividend that is usually much larger than a regular dividend. C. The way a firm chooses between paying dividends and retaining earnings is referred to as its payout policy. D. From an accounting perspective, dividends generally reduce the firm's current (or accumulated) retained earnings.
A. Most companies that pay dividends pay them semiannually.
The advantages of going public include which of the following? (Select all of the choices below that apply.) A. One advantage of going public is increased liquidity. It is easier to buy and sell the company's shares. B. Decreased exposure to sources of capital is another advantage of going public. C. Increased access to capital markets is a primary advantage of going public. D. A very significant advantage of going public is that by doing so a firm can satisfy all of the requirements of being a public company such as SEC filings and listing requirements of the securities exchanges.
A. One advantage of going public is increased liquidity. It is easier to buy and sell the company's shares. Your answer is correct. C. Increased access to capital markets is a primary advantage of going public. Your answer is correct.
What are the advantages of a rights offer? (Select all of the choices below that apply.) A. Rights offers protect existing shareholders from underpricing, because, with a rights offer, only existing shareholders are offered stock to purchase. B. With a cash offer, demand may be lower, because existing shareholders are only a subset of all possible investors and they may not want to increase the percentage weight of this stock in their portfolios. C. With a rights offer, demand may be lower, because existing shareholders are only a subset of all possible investors and they may not want to increase the percentage weight of this stock in their portfolios. D. If demand is lower, firms may receive a lower price from rights offers.
A. Rights offers protect existing shareholders from underpricing, because, with a rights offer, only existing shareholders are offered stock to purchase. C. With a rights offer, demand may be lower, because existing shareholders are only a subset of all possible investors and they may not want to increase the percentage weight of this stock in their portfolios. D. If demand is lower, firms may receive a lower price from rights offers.
Which of the following statements regarding exit strategies is FALSE? A. Roughly 25% of venture capital exits from 2002−2012 occurred through mergers or acquisitions. B. An important consideration for investors in private companies is their exit strategy or how they will eventually realize the return from their investment. C. An alternative way to provide liquidity to its investors is for the company to become a publicly traded company. D. Often large corporations purchase successful start−up companies. In such a case, the acquiring company purchases the outstanding stock of the private company, allowing all investors to cash out.
A. Roughly 25% of venture capital exits from 2002−2012 occurred through mergers or acquisitions.
Which of the following statements is FALSE? A. The WACC incorporates the benefit of the interest tax shield by using the firm's before−tax cost of capital for debt. B. Because the WACC incorporates the tax savings from debt, we can compute the levered value of an investment, which is its value including the benefit of interest tax shields given the firm's leverage policy, by discounting its future free cash flow using the WACC. C. When the market risk of the project is similar to the average market risk of the firm's investments, then its cost of capital is equivalent to the cost of capital for a portfolio of all of the firm's securities; that is, the project's cost of capital is equal to the firm's weighted average cost of capital (WACC). D. A project's cost of capital depends on its risk.
A. The WACC incorporates the benefit of the interest tax shield by using the firm's before−tax cost of capital for debt.
Which of the following is NOT one of the simplifying assumptions made for the three main methods of capital budgeting? A. The firm pays out all earnings as dividends. B. Corporate taxes are the only market imperfection. C. The firm's debt−equity ratio is constant. D. The project has average risk.
A. The firm pays out all earnings as dividends.
The advantages to a private company of raising money from a corporate investor include which of the following? (Select all of the choices that apply.) A. The large corporate partner may provide benefits such as capital, expertise, or access to distribution channels. B. The corporate partner may become an important customer or supplier for the startup firm. C. The corporate investor can shield the startup from initial taxes by providing carryover tax losses to the fledging firm. D. The willingness of an established company to invest may be an important endorsement of the new company.
A. The large corporate partner may provide benefits such as capital, expertise, or access to distribution channels. B. The corporate partner may become an important customer or supplier for the startup firm. D. The willingness of an established company to invest may be an important endorsement of the new company.
Which of the following statements is FALSE? A. The lessee is the owner of the asset, who is entitled to the lease payments in exchange for lending the asset. B. A lease is a contract between two parties: the lessee and the lessor. C. Most leases involve little or no upfront payment. D. At the end of the contract term, the lease specifies who will retain ownership of the asset and at what terms.
A. The lessee is the owner of the asset, who is entitled to the lease payments in exchange for lending the asset.
Which of the following statements is FALSE? A. The preferred stock issued by young companies usually gives the owner an option to convert it into common stock on some future date, so it is often called callable preferred stock. B. The preferred stock issued by young companies typically does not pay regular cash dividends. C. If the company runs into financial difficulties, the preferred stockholders have a senior claim on the assets of the firm relative to any common stockholders. D. Preferred stock issued by mature companies such as banks usually has a preferential dividend and seniority in any liquidation and sometimes special voting rights.
A. The preferred stock issued by young companies usually gives the owner an option to convert it into common stock on some future date, so it is often called callable preferred stock.
When might it be advantageous to undertake a reverse stock split? A. To avoid being delisted from an exchange because the price of the stock has fallen below the minimum share price required to stay listed. B. In bad times, to signal future good times. C. There is no good reason to do a reverse stock split—just ask Warren Buffet. D. When the stock price is over $100.
A. To avoid being delisted from an exchange because the price of the stock has fallen below the minimum share price required to stay listed.
What is IPO underpricing? If you decide to try to buy shares in every IPO, will you necessarily make money from the underpricing? (Select all of the choices that apply.) A. Underpricing refers to the fact that, on average, underwriters pick the IPO issue price so that the average first-day return is positive. B. Underpricing refers to the fact that, on average, underwriters pick the IPO issue price so that the average first-day return is negative. C. If you followed a strategy of placing an order for a fixed number of shares on every IPO, your order will be completely filled when the stock price goes down, but you will be rationed when it goes up. In effect you only get substantial amounts of stock when you do not want it. The winners' curse is substantial enough so that the strategy of investing in every IPO does not yield above market returns. D. If you followed a strategy of placing an order for a fixed number of shares on every IPO, your order will be completely filled when the stock price goes up, but you will be rationed when it goes down. In effect you only get substantial amounts of stock when you do not want it. The winners' curse is substantial enough so that the strategy of investing in every IPO does not yield above market returns.
A. Underpricing refers to the fact that, on average, underwriters pick the IPO issue price so that the average first-day return is positive. C. If you followed a strategy of placing an order for a fixed number of shares on every IPO, your order will be completely filled when the stock price goes down, but you will be rationed when it goes up. In effect you only get substantial amounts of stock when you do not want it. The winners' curse is substantial enough so that the strategy of investing in every IPO does not yield above market returns.
Which of the following statements is FALSE? A. When securities are fairly priced, the original shareholders of a firm pay the future value of the costs associated with bankruptcy and financial distress. B. The costs of financial distress represent an important departure from Modigliani and Miller's assumption of perfect capital markets. C. Debt holders are not foolish—they recognize that when the firm defaults, they will not be able to get the full value of the assets. As a result, they will pay less for the debt initially. D. Levered firms risk incurring financial distress costs that reduce the cash flows available to investors.
A. When securities are fairly priced, the original shareholders of a firm pay the future value of the costs associated with bankruptcy and financial distress.
Which of the following statements is FALSE? A. When we relax the assumption of a constant debt−equity ratio, the FTE method is relatively straightforward to use and is therefore the preferred method with alternative leverage policies. B. With a constant interest coverage policy, the value of the interest tax shield is proportional to the project's unlevered value. C. When the firm keeps its interest payments to a target fraction of its FCF, we say it has a constant interest coverage ratio. D. When debt levels are set according to a fixed schedule, we can discount the predetermined interest tax shields using the debt cost of capital, rD.
A. When we relax the assumption of a constant debt−equity ratio, the FTE method is relatively straightforward to use and is therefore the preferred method with alternative leverage policies.
A type of agency problem that results in shareholders gaining from decisions that increase the risk of the firm sufficiently, even if they have negative NPV is: A. asset substitution. B. cashing out. C. debt overhang. D. underinvestment.
A. asset substitution.
The share of any positive return generated by venture capital firms that is taken by the firm's partners is known as: A. carried interest. B. angel interest. C. carried capital. D. partner return.
A. carried interest.
A type of agency problem that results in shareholders gaining by choosing not to finance new, positive−NPV projects is: A. debt overhang. B. distress costs. C. excessive risk−taking. D. asset substitution.
A. debt overhang.
A lease that gives the lessee the option to purchase the asset at its fair market value at the termination of the lease is called a: A. fair market value lease. B. fair market value cap lease. C. $1.00 out lease. D. fixed price lease.
A. fair market value lease.
The idea that managers who perceive the firm's equity is underpriced will have a preference to fund investment using retained earnings, or debt, rather than equity is known as the: A. pecking order hypothesis. B. lemons principle. C. credibility principle. D. signaling theory of debt.
A. pecking order hypothesis.
A(n) ________ may occur if a major shareholder desires to sell a large number of shares but the market for the shares is not sufficiently liquid to sustain such a large sale without severely affecting the price. A. targeted repurchase B. Dutch auction share repurchase C. tender offer D. open market share repurchase
A. targeted repurchase
The term rE in this equation is: A. the required rate of return on equity. B. the required rate of return on debt. C. the after−tax required rate of return on debt. D. the dollar amount of equity.
A. the required rate of return on equity.
The assumption that the firm's debt−equity ratio is constant means: A. the firm's cost of capital will not fluctuate when it accepts a new project. B. the risk of its debt and equity will change when it accepts a new project. C. the firm adjusts its leverage to maintain a constant debt−equity ratio in terms of book value. D. corporate taxes are the only imperfection.
A. the firm's cost of capital will not fluctuate when it accepts a new project.
Describe the different mechanisms available to a firm for repurchasing shares. There are three mechanisms: (Select the best choice below.) A. 1) In an open market repurchase, the firm repurchases the shares in the open market. This is the most common mechanism in the United States. B. 2) In a tender offer, the firm announces the intention to repurchase a fixed number of shares for a fixed price, conditional on shareholders agreeing to tender their shares. Even if not enough shares are tendered, the firm is obligated to repurchase the shares that are tendered. C. 2) In a tender offer, the firm announces the intention to all shareholders to repurchase a fixed number of shares for a fixed price, conditional on shareholders agreeing to tender their shares. If not enough shares are tendered, the deal can be cancelled. D. 3) A targeted repurchase is similar to a tender offer except that it is not open to all shareholders; only specific shareholders can tender their shares in a targeted repurchase.
A. 1) In an open market repurchase, the firm repurchases the shares in the open market. This is the most common mechanism in the United States. C. 2) In a tender offer, the firm announces the intention to all shareholders to repurchase a fixed number of shares for a fixed price, conditional on shareholders agreeing to tender their shares. If not enough shares are tendered, the deal can be cancelled. D. 3) A targeted repurchase is similar to a tender offer except that it is not open to all shareholders; only specific shareholders can tender their shares in a targeted repurchase.
Which of the following statements is FALSE? A. The intuition for the WACC method is that the firm's weighted average cost of capital represents the average return the firm must pay to its investors (both debt and equity holders) on an after−tax basis. B. A disadvantage of the WACC method is that you need to know how the firm's leverage policy is implemented to make the capital budgeting decision. C. The WACC can be used throughout the firm as the company wide cost of capital for new investments that are of comparable risk to the rest of the firm and that will not alter the firm's debt−equity ratio. D. To be profitable, a project should generate an expected return of at least the firm's weighted average cost of capital.
B. A disadvantage of the WACC method is that you need to know how the firm's leverage policy is implemented to make the capital budgeting decision.
Which of the following statements is FALSE? A. Covenants may limit the firm's ability to pay large dividends or the types of investments that the firm can make. B. Agency costs are smallest for long−term debt. C. Covenants are often designed to prevent management from exploiting debt holders, so they may help to reduce agency costs. D. Creditors often place restrictions on the actions that the firm can take. Such restrictions are referred to as debt covenants.
B. Agency costs are smallest for long−term debt.
Which of the following statements regarding the adjusted present value method is FALSE? A. When the firm maintains a target leverage ratio, its future interest tax shields have similar risk to the project's cash flows, so they should be discounted at the project's unlevered cost of capital. B. A firm's levered cost of capital is a weighted average of its equity and debt costs of capital. C. The first step in the APV method is to calculate the value of free cash flows using the project's cost of capital if it were financed without leverage. D. The firm's unlevered cost of capital is equal to its pre−tax weighted average cost of capital—that is, using the pre−tax cost of debt, rd, rather than its after−tax cost, rd (1 − τc ).
B. A firm's levered cost of capital is a weighted average of its equity and debt costs of capital.
Which of the following is NOT an indirect cost of bankruptcy? A. Loss of suppliers B. Costs of appraisers C. Loss of employees D. Fire sales of assets
B. Costs of appraisers
Which of the following is NOT a direct cost of bankruptcy? A. Costs of accounting experts B. Costs to creditors C. Investment banking costs D. Legal costs and fees
B. Costs to creditors
Which of the following statements is FALSE? A. In the extreme case, the debt holders take legal ownership of the firm's assets through a process called bankruptcy. B. Equity holders expect to receive dividends and the firm is legally obligated to pay them. C. After a firm defaults, debt holders are given certain rights to the assets of the firm. D. A firm that fails to make the required interest or principal payments on the debt is in default.
B. Equity holders expect to receive dividends and the firm is legally obligated to pay them.
Which of the following statements is FALSE? A. When used consistently, the WACC, APV, and FTE methods produce the same valuation for the investment. B. For alternative leverage policies, the FTE method is usually the most straightforward approach. C. The FTE method is typically used only in complicated settings for which the values of other securities in the firm's capital structure or the interest tax shield are themselves difficult to determine. D. As a general rule, the WACC method is the easiest to use when the firm will maintain a fixed debt−to−value ratio over the life of the investment.
B. For alternative leverage policies, the FTE method is usually the most straightforward approach.
Which of the following statements regarding best efforts IPOs is FALSE? A. Often these arrangements have an all−or−none clause: either all of the shares are sold in the IPO, or the deal is called off. B. If the entire issue does not sell out, the underwriter is on the hook for the unsold shares. C. The underwriter does not guarantee that the stock will be sold, but instead tries to sell the stock for the best possible price. D. For smaller IPOs, the underwriter commonly accepts the deal on this basis.
B. If the entire issue does not sell out, the underwriter is on the hook for the unsold shares.
Which of the following statements is FALSE? A. Historically, intermediaries would advertise the sale of stock (both IPOs and SEOs) by taking out advertisements in newspapers called tombstones. B. In a cash offer, the firm offers the new shares to existing shareholders. C. Today, investors become informed about the impending sale of stock by the news media, via a road show, or through the book−building process, so tombstones are purely ceremonial. D. Primary shares are new shares issued by the company.
B. In a cash offer, the firm offers the new shares to existing shareholders.
Which of the following statements is FALSE? A. The lease specifies any cancellation provisions, the options for renewal and purchase, and the obligations for maintenance and related servicing costs. B. In a direct lease, the lessor is the manufacturer (or a primary dealer) of the asset. C. If a firm already owns an asset it would prefer to lease, it can arrange a sale and leaseback transaction. D. With many leases, the lessor provides the initial capital necessary to purchase the asset, and then receives and retains the lease payments.
B. In a direct lease, the lessor is the manufacturer (or a primary dealer) of the asset.
Which of the following statements is FALSE? A. In perfect capital markets, holding fixed the investment policy of a firm, the firm's choice of dividend policy is irrelevant and does not affect the initial share price. B. In perfect capital markets, an open market share repurchase has no effect on the stock price, and the stock price is the same as the ex−dividend price if a dividend were paid instead. C. In perfect capital markets, investors are indifferent between the firm distributing funds via dividends or share repurchases. By reinvesting dividends or selling shares, they can replicate either payout method on their own. D. In a perfect capital market, when a dividend is paid, the share price drops by the amount of the dividend when the stock begins to trade ex−dividend.
B. In perfect capital markets, an open market share repurchase has no effect on the stock price, and the stock price is the same as the ex−dividend price if a dividend were paid instead.
Which of the following is NOT an indirect cost of bankruptcy? A. Delayed liquidation B. Legal fees C. Costs to creditors D. Loss of customers
B. Legal fees
Under which conditions can an increase in the dividend payment be interpreted as a signal of bad news: (Select the best choice below.) A. Raising dividends requires borrowing money and increasing debt, which is bad news. B. Raising dividends signals that the firm does not have any positive NPV investment opportunities, which is bad news. C. Raising dividends means paying out more cash, leaving less cash in the firm, and thus reducing value, which is bad news. D. Raising dividends for no reason signals management's desire to manipulate investors, which is a waste of managerial resources, which is bad news.
B. Raising dividends signals that the firm does not have any positive NPV investment opportunities, which is bad news.
Which of the following statements is FALSE? A. Although not as costly as IPOs, seasoned offerings are still expensive. B. Researchers have found that, on average, the market greets the news of an SEO with a price increase. C. The decision to raise financing externally usually implies that a firm plans to pursue an investment opportunity. D. SEO rights offers have lower costs than cash offers.
B. Researchers have found that, on average, the market greets the news of an SEO with a price increase.
The disadvantages to a private company of raising money from a corporate investor include: (Select all of the choices that apply.) A. The disadvantages of linking up with a corporate investor are minimal. This is because most corporate investments are successful and small firms must be willing to put aside small inconveniences for a greater chance of success. B. The corporate partner may gain access to proprietary technology, or eventually even become a competitor. C. One disadvantage of borrowing from a corporation is that the small firm may become so successful that it will outgrow the need of a corporate investor. D. Once a young firm has aligned itself with one corporate partner, the competitors of this partner may be unwilling to do business with the startup
B. The corporate partner may gain access to proprietary technology, or eventually even become a competitor. D. Once a young firm has aligned itself with one corporate partner, the competitors of this partner may be unwilling to do business with the startup
Which of the following is NOT one of the four characteristics of IPOs that puzzle financial economists? A. The costs of the IPO are very high, and it is unclear why firms willingly incur such high costs. B. The long−run performance of the average newly public company (three to five years from the date of issue) is superior to the overall market return. C. On average, IPOs appear to be underpriced. D. The number of IPO issues is highly cyclical.
B. The long−run performance of the average newly public company (three to five years from the date of issue) is superior to the overall market return.
Which of the following statements is FALSE? A. Organizations such as the Securities and Exchange Commission (SEC), the securities exchanges (including the New York Stock Exchange and the NASDAQ), and Congress (through the Sarbanes−Oxley Act of 2002) adopted new standards that focused on more thorough financial disclosure, greater accountability, and more stringent requirements for the board of directors. B. The major advantage of undertaking an IPO is also one of the major disadvantages of an IPO: When investors diversify their holdings, the equity holders of the corporation become more concentrated. C. Several high−profile corporate scandals during the early part of the twenty−first century prompted tougher regulations designed to address corporate abuses. D. Once a company goes public, it must satisfy all of the requirements of public companies.
B. The major advantage of undertaking an IPO is also one of the major disadvantages of an IPO: When investors diversify their holdings, the equity holders of the corporation become more concentrated
Which of the following statements is FALSE? A. Shareholders typically must pay taxes on the dividends they receive. They must also pay capital gains taxes when they sell their shares. B. Unlike with capital structure, taxes are not an important market imperfection that influence a firm's decision to pay dividends or repurchase shares. C. If dividends are taxed at a higher rate than capital gains, which has been true until the most recent change to the tax code, shareholders will prefer share repurchases to dividends. D. Because long−term investors can defer the capital gains tax until they sell, there is still a tax advantage for share repurchases over dividends.
B. Unlike with capital structure, taxes are not an important market imperfection that influence a firm's decision to pay dividends or repurchase shares.
Which of the following statements is FALSE? A. The initial capital that is required to start a business is usually provided by the entrepreneur herself and her immediate family. B. Venture capitalists typically control about three−quarters of the seats on a start−up's board of directors, and often represent the single largest voting block on the board. C. Individual investors who buy equity in small private firms are called angel investors. D. A venture capital firm is a limited partnership that specializes in raising money to invest in the private equity of young firms.
B. Venture capitalists typically control about three−quarters of the seats on a start−up's board of directors, and often represent the single largest voting block on the board.
Which of the following statements is FALSE? A. 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. B. When a firm fails to make a required payment to debt holders, it is in bankruptcy. C. 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. D. 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.
B. When a firm fails to make a required payment to debt holders, it is in bankruptcy.
Which of the following statements is FALSE? A. Economic distress is a significant decline in the value of a firm's assets, whether or not it experiences financial distress due to leverage. B. Whether default occurs depends on the cash flows, not on the relative values of the firm's assets and liabilities. C. Modigliani and Miller's results continue to hold in a perfect market even when debt is risky and the firm may default. D. An important consequence of leverage is the risk of bankruptcy.
B. Whether default occurs depends on the cash flows, not on the relative values of the firm's assets and liabilities.
The term moral hazard refers to: A. the under−investment problem. B. the idea that individuals will change their behavior if they are not fully exposed to its consequences. C. the chance the firm will default and impose losses on its debt holders. D. the over−investment problem.
B. the idea that individuals will change their behavior if they are not fully exposed to its consequences.
Which of the following statements is FALSE? A. 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. B. In the more common form of bankruptcy for large corporations, Chapter 11 reorganization, all pending collection attempts are automatically suspended, and the firm's existing management is given the opportunity to propose a reorganization plan. C. 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. D. While developing a Chapter 11 reorganization plan, management continues to operate the business.
C. 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.
Which of the following statements is FALSE? A. Because the assets of the firm might be more valuable if kept together, creditors seizing assets in a piecemeal fashion might destroy much of the remaining value of the firm. B. The U.S. bankruptcy code was created to organize this process so that creditors are treated fairly and the value of the assets is not needlessly destroyed. C. Because most firms have multiple creditors, coordination makes it difficult to guarantee that each creditor will be treated fairly. D. Debt holders can then take legal action against the firm to collect payment by seizing the firm's assets.
C. Because most firms have multiple creditors, coordination makes it difficult to guarantee that each creditor will be treated fairly.
Which of the following explains why most companies choose to pay stock dividends (split their stock)? (Select the best choice below.) A. Stock splits increase the amount of stock each investor holds, thus increasing investor welfare. B. There is no good reason to do a stock split—just ask Warren Buffet. C. Companies use stock splits to keep their stock prices in a range that reduces investor transaction costs. D. By splitting the stock, investors get a stock dividend which increases value.
C. Companies use stock splits to keep their stock prices in a range that reduces investor transaction costs.
Which of the following statements is FALSE? A. 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. B. 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. C. Firms with high R&D costs and future growth opportunities typically maintain high debt levels. D. The tradeoff theory explains how firms should choose their capital structures to maximize value to current shareholders.
C. Firms with high R&D costs and future growth opportunities typically maintain high debt levels.
Which of the following statements is FALSE? A. We can estimate rU for a new project by looking at single−division firms that have similar business risks. B. The project's equity cost of capital depends on its unlevered cost of capital, rU, and the debt−equity ratio of the incremental financing that will be put in place to support the project. C. In the real world, specific projects should differ only slightly from the average investment made by the firm. D. Projects may vary in the amount of leverage they will support—for example, acquisitions of real estate or capital equipment are often highly levered, whereas investments in intellectual property are not.
C. In the real world, specific projects should differ only slightly from the average investment made by the firm.
Which of the following statements is FALSE? A. The costs of reduced effort and excessive spending on perks are another form of agency cost. B. The separation of ownership and control creates the possibility of management entrenchment; facing little threat of being fired and replaced, managers are free to run the firm in their own best interests. C. One disadvantage of using leverage is that it does not allow the original owners of the firm to maintain their equity stake. D. Managers also have their own personal interests, which may differ from those of both equity holders and debt holders.
C. One disadvantage of using leverage is that it does not allow the original owners of the firm to maintain their equity stake.
The disadvantages of going public include which of the following? (Select all of the choices below that apply.) A. One major disadvantage of going public is reduced access to capital markets. B. One disadvantage of going public is decreased liquidity. The original owners of the company find it more difficult to sell their shares because of insider-trading laws. C. One of the major disadvantages of an IPO is that once a company becomes a public company, it must satisfy all of the requirements of being a public company such as SEC filings and listing requirements of the securities exchanges. D. When investors diversify their holdings, the equity holders of the corporation become more widely dispersed. This lack of ownership concentration undermines investors' ability to monitor the company's management, and investors may discount the price they are willing to pay to reflect the loss of control.
C. One of the major disadvantages of an IPO is that once a company becomes a public company, it must satisfy all of the requirements of being a public company such as SEC filings and listing requirements of the securities exchanges. D. When investors diversify their holdings, the equity holders of the corporation become more widely dispersed. This lack of ownership concentration undermines investors' ability to monitor the company's management, and investors may discount the price they are willing to pay to reflect the loss of control.
Which of the following statements is FALSE? A. Underwriters appear to use the information they acquire during the book−building stage to intentionally underprice the IPO, thereby reducing their exposure to losses. B. The lead underwriter usually makes a market in the stock and assigns an analyst to cover it. C. The blue tooth option allows the underwriter to issue more stock, amounting to 15% of the original offer size, at the IPO offer price. D. In most cases, the preexisting shareholders are subject to a 180−day lockup; they cannot sell their shares for 180 days after the IPO. Once the lockup period expires, they are free to sell their shares.
C. The blue tooth option allows the underwriter to issue more stock, amounting to 15% of the original offer size, at the IPO offer price.
Which of the following statements is FALSE? A. The tradeoff theory states that firms should increase their leverage until it reaches the level D* for which VL is maximized. B. 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. C. 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. D. 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.
C. 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.
Which of the following statements is FALSE? A. Many IPOs, especially the larger offerings, are managed by a group of underwriters. B. At an IPO, a firm offers a large block of shares for sale to the public for the first time. C. The shares that are sold in the IPO may either be new shares that raise new capital, known as a secondary offering, or existing shares that are sold by current shareholders (as part of their exit strategy), known as a primary offering. D. After deciding to go public, managers of the company work with an underwriter, an investment banking firm that manages the offering and designs its structure.
C. The shares that are sold in the IPO may either be new shares that raise new capital, known as a secondary offering, or existing shares that are sold by current shareholders (as part of their exit strategy), known as a primary offering.
Which of the following statements is NOT true regarding venture capitalists? A. They offer limited partners a number of advantages over investing directly in start−ups themselves as angel investors. B. They can provide substantial capital for young companies. C. They might invest for strategic objectives in addition to the desire for investment returns. D. They use their control to protect their investments, so they may therefore perform a key nurturing and monitoring role for the firm.
C. They might invest for strategic objectives in addition to the desire for investment returns.
Which of the following statements is FALSE? A. When we relax the assumption of a constant debt−equity ratio, the equity cost of capital and WACC for a project will change over time as the debt−equity ratio changes. B. If a firm is using leverage to shield income from corporate taxes, then it will adjust its debt level so that its interest expenses grow with its earnings. C. When we relax the assumption of a constant debt−equity ratio, the APV and FTE methods are difficult to implement. D. Rather than set debt according to a target debt−equity ratio or interest coverage level, a firm may adjust its debt according to a fixed schedule that is known in advance.
C. When we relax the assumption of a constant debt−equity ratio, the APV and FTE methods are difficult to implement.
Which of the following statements is FALSE? A. The bankruptcy code is designed to provide an orderly process for settling a firm's debts. B. 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. C. 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. D. In addition to the money spent by the firm, the creditors may incur costs during the bankruptcy process.
C. 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.
The date on which the board of directors authorizes the dividend is the: A. record date. B. ex−dividend date. C. declaration date. D. distribution date.
C. declaration date.
The firm mails dividend checks to the registered shareholders on the: A. declaration date. B. ex−dividend date. C. distribution date. D. record date.
C. distribution date.
A lease where the lessee has the option to purchase the asset at the end of the lease for a price that is set upfront in the lease contract is called a: A. $1.00 out lease. B. fair market value lease. C. fixed price lease. D. fair market value cap lease.
C. fixed price lease.
A(n) ________ is the most common way that firms repurchase shares. A. targeted repurchase B. tender offer C. open market share repurchase D. Dutch auction share repurchase
C. open market share repurchase
A(n) ________ invests in the equity of existing privately held firms. Question content area bottom Part 1 A. venture capital firm B. private debt firm C. private equity firm D. vulture fund
C. private equity firm
The firm will pay the dividend to all shareholders who are registered owners on a specific date, set by the board, called the: A. ex−dividend date. B. distribution date. C. record date. D. declaration date.
C. record date.
A part of the registration statement, called the preliminary prospectus, circulates to investors before the stock is offered. This preliminary prospectus is also called a(n): A. 10−K filing. B. IPO filing. C. red herring. D. blue whale.
C. red herring.
The term D in this equation is: A. the required rate of return on debt. B. the required rate of return on equity. C. the dollar amount of debt. D. the dollar amount of equity.
C. the dollar amount of debt.
Consider the following equation: rwacc = E/E + D*rE + D/E + D*rD*(1 − τc) the term E in this equation is: A. the required rate of return on debt. B. the dollar amount of debt. C. the dollar amount of equity. D. the required rate of return on equity.
C. the dollar amount of equity.
Which of the following is NOT a step in the WACC valuation method? A. Determine the free cash flow of the investment. B. Compute the weighted average cost of capital. C. Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment using the WACC. D. Adjust the WACC for the firm's current debt/equity ratio.
D. Adjust the WACC for the firm's current debt/equity ratio.
Which of the following methods are used in capital budgeting decisions? A. Weighted average cost of capital (WACC) method B. Adjusted present value (APV) method C. Flow−to−equity (FTE) method D. All of the above are used in capital budgeting decisions.
D. All of the above are used in capital budgeting decisions.
Which of the following influences a firm's choice of capital structure? A. Taxes B. Signaling and adverse selection C. Agency costs and benefits of leverage D. All of the above influence capital structure decisions.
D. All of the above influence capital structure decisions.
In 2018, Mastercard Incorporated had a market capitalization of $200 billion, debt of $6.5 billion, cash of $8.2 billion, and EBIT of nearly $7 billion. If Mastercard were to increase its debt by $1 billion and use the cash for a share repurchase, which market imperfections would be most relevant for understanding the consequence for Mastercard's value? Why? A. Mastercard's debt is a tiny fraction of its total value. Indeed, Mastercard has more cash than debt, so its net debt is negative. Mastercard is also very profitable; at an interest rate of 6%, interest on Mastercard's debt is only $390million per year, which is around 5.57% of its EBIT. B. The risk that Mastercard will default on its debt is extremely small. This risk will remain extremely small even if Mastercard borrows an additional $1 billion. Thus, adding debt will not really change the likelihood of financial distress for Mastercard (which is nearly zero), and thus will also not lead to agency conflicts. C. The most important financial friction for such a debt increase is the tax savings Mastercard would receive from the interest tax shield. A secondary issue may be the signaling impact of the transaction-borrowing to do a share repurchase is usually interpreted as a positive signal that management may view the shares to be underpriced. D. All of the above.
D. All of the above.
What options does a firm have to spend its free cash flow (after it has satisfied all interest obligations)? A. Use it to make investments. B. Use it to repurchase shares. C. Pay it out as dividends. D. All of the above.
D. All of the above.
Which of the following statements is FALSE? A. When a firm issues stock using an SEO, it follows many of the same steps as for an IPO. The main difference is that a market price for the stock already exists, so the price−setting process is not necessary. B. More often than not, firms return to the equity markets and offer new shares for sale, a type of offering called a seasoned equity offering (SEO). C. Usually, profitable growth opportunities occur throughout the life of the firm, and in some cases, it is not feasible to finance these opportunities out of retained earnings. D. A firm's need for outside capital usually ends at the IPO.
D. A firm's need for outside capital usually ends at the IPO.
Which of the following statements is FALSE? A. Two key qualitative factors determine the present value of financial distress costs: (1) the probability of financial distress and (2) the magnitude of the costs after a firm is in distress. B. Technology firms are likely to incur high costs when they are in financial distress, due to the potential for loss of customers and key personnel, as well as a lack of tangible assets that can be easily liquidated. C. The magnitude of the financial distress costs will depend on the relative importance of the sources of these costs and is likely to vary by industry. D. Calculating the precise present value of financial distress costs is a relatively straightforward process.
D. Calculating the precise present value of financial distress costs is a relatively straightforward process.
One method of repurchasing shares is the ________, in which the firm lists different prices at which it is prepared to buy shares, and shareholders in turn indicate how many shares they are willing to sell at each price. A. targeted repurchase B. tender offer C. open market share repurchases D. Dutch auction share repurchase
D. Dutch auction share repurchase
Which of the following statements is FALSE? A. Secondary shares are shares sold by existing shareholders, including the company's founder. B. In a rights offer, the firm offers the new shares only to existing shareholders. C. If a firm's management is concerned that its equity may be underpriced in the market, by using a rights offering the firm can continue to issue equity without imposing a loss on its current shareholders. D. In the United States, most offers are rights offers.
D. In the United States, most offers are rights offers.
Which of the following statements is FALSE? A. While an increase of a firm's dividend may signal management's optimism regarding its future cash flows, it might also signal a lack of investment opportunities. B. Managers will clearly be more likely to repurchase shares if they believe the stock to be under−valued. C. Share repurchases are a credible signal that the shares are underpriced, because if they are over−priced a share repurchase is costly for current shareholders. D. Managers are much less committed to dividend payments than to share repurchases.
D. Managers are much less committed to dividend payments than to share repurchases.
Which of the following questions is FALSE? A. An alternative method of incorporating financial distress and agency costs is to first value the project ignoring these costs, and then value the incremental cash flows associated with financial distress and agency problems separately. B. When the debt level—and, therefore, the probability of financial distress—is high, the expected free cash flow will be reduced by the expected costs associated with financial distress and agency problems. C. If the financing of the project involves an equity issue, and if management believes that the equity will sell at a price that is less than its true value, this mispricing is a cost of the project for the existing shareholders. D. Sometimes management may believe that the securities they are issuing are priced at less than (or more than) their true value. If so, the NPV of the transaction, which is the difference between the actual money raised and the true value of the securities sold, should not be included in the value of the project.
D. Sometimes management may believe that the securities they are issuing are priced at less than (or more than) their true value. If so, the NPV of the transaction, which is the difference between the actual money raised and the true value of the securities sold, should not be included in the value of the project.
Which of the following statements is FALSE? A. An under−investment problem occurs when shareholders choose to not invest in a positive−NPV project. B. When a firm faces financial distress, it may choose not to finance new, positive−NPV projects. C. Agency costs represent another cost of increasing the firm's leverage that will affect the firm's optimal capital structure choice. D. The agency costs of debt can arise only if there is no chance the firm will default and impose losses on its debt holders.
D. The agency costs of debt can arise only if there is no chance the firm will default and impose losses on its debt holders.
Which of the following questions is FALSE? A. The WACC, APV, and FTE methods determine the value of an investment incorporating the tax shields associated with leverage. B. When a firm borrows funds, a mispricing scenario arises if the interest rate charged differs from the rate that is appropriate given the actual risk of the loan. C. With perfect capital markets, all securities are fairly priced and issuing securities is a zero−NPV transaction. D. The fees associated with the financing of a project are independent of the project's required cash flows and should be ignored when calculating the NPV of the project.
D. The fees associated with the financing of a project are independent of the project's required cash flows and should be ignored when calculating the NPV of the project.
Which of the following statements is FALSE? A. By going public, companies give their private equity investors the ability to diversify. B. Public companies typically have access to much larger amounts of capital through the public markets. C. The two advantages of going public are greater liquidity and better access to capital. D. The process of selling stock to the public for the first time is called a seasoned equity offering (SEO).
D. The process of selling stock to the public for the first time is called a seasoned equity offering (SEO).
Which of the following statements regarding firm commitment IPOs is FALSE? A. If the entire issue does not sell out, the remaining shares must be sold at a lower price and the underwriter must take the loss. B. The underwriter guarantees that it will sell all of the stock at the offer price. C. It is the most common underwriting arrangement. D. The underwriter purchases the entire issue (at the offer price) and then resells it at a slightly higher price to interested investors.
D. The underwriter purchases the entire issue (at the offer price) and then resells it at a slightly higher price to interested investors.
Which of the following statements is NOT true regarding Angel Investors? A. These investors are frequently friends or acquaintances of the entrepreneur. B. Because their capital investment is often large relative to the amount of capital already in place at the firm, they typically receive a sizeable equity share in the business in return for their funds. C. For many start−ups, the first round of outside private equity financing is often obtained from them. D. They are typically arranged as limited partnerships.
D. They are typically arranged as limited partnerships.
Which of the following is NOT a common name for a corporation that invests in private companies? A. Strategic investor B. Strategic partner C. Corporate partner D. Venture partner
D. Venture partner
Which of the following statements is FALSE? A. The general partners work for the venture capital firm and run the venture capital firm; they are called venture capitalists. B. Institutional investors such as pension funds, insurance companies, endowments, and foundations manage large quantities of money. C. An important consideration for investors in private companies is their exit strategy—how they will eventually realize the return from their investment. D. When a company founder decides to sell equity to outside investors for the first time, it is common practice for private companies to issue common stock rather than preferred stock to raise capital.
D. When a company founder decides to sell equity to outside investors for the first time, it is common practice for private companies to issue common stock rather than preferred stock to raise capital.
Which of the following statements is FALSE? A. 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. B. Agency costs are costs that arise when there are conflicts of interest between stakeholders. C. In some circumstances, managers may take actions that benefit shareholders but harm the firm's creditors and lower the total value of the firm. D. When a firm faces financial distress, creditors can gain by making sufficiently risky investments, even if they have negative NPV.
D. When a firm faces financial distress, creditors can gain by making sufficiently risky investments, even if they have negative NPV.
Which of the following statements is FALSE? A. While overspending on personal perks may be a problem for large firms, these costs are likely to be small relative to the overall value of the firm. B. A serious concern for large corporations is that managers may make large, unprofitable investments. C. Some financial economists explain a manager's willingness to engage in negative−NPV investments as empire building. D. While ownership is often diluted for small, young firms, ownership typically becomes concentrated over time as a firm grows.
D. While ownership is often diluted for small, young firms, ownership typically becomes concentrated over time as a firm grows.
Anyone who purchases the stock on or after the ________ date will not receive the dividend. A. declaration B. distribution C. record D. ex−dividend
D. ex−dividend
When a private equity firm purchases the outstanding equity of a publicly traded firm, thereby taking the company private, the transaction is called a(n): A. cash offer. B. private leveraged transaction. C. initial public offering. D. leveraged buyout.
D. leveraged buyout.
A firm can repurchase shares through a(n) ________ in which it offers to buy shares at a prespecified price during a short time period—generally within 20 days. A. Dutch auction share repurchase B. targeted repurchase C. open market share repurchase D. tender offer
D. tender offer
The term rD(1 − τc) in this equation is: A. the required rate of return on equity. B. the required rate of return on debt. C. the dollar amount of equity. D. the after−tax required rate of return on debt.
D. the after−tax required rate of return on debt.
Aaron Inc went public at $10 per share. Aaron's investment banker charged them $0.70 per share for the IPO. This fee is called a(n): Question content area bottom Part 1 A. allocation spread. B. greenshoe fee. C. IPO fee. D. underwriting spread.
D. underwriting spread.
