Question 1

A type of agency problem that results in shareholders gaining by choosing not to finance new,positive-NPV projects is:

Accepted Answer

A) asset substitution. 
B) debt overhang. 
C) excessive risk-taking. 
D) distress costs. 
A) asset substitution. 
B) debt overhang. 
C) excessive risk-taking. 
D) distress costs. B

Question 2

Use the following information to answer the question(s)below.
Suppose that you have received two job offers.Rearden Metal offers you a contract for $75,000 per year for the next two years while Wyatt Oil offers you a contract for $90,000 per year for the next two years.Both jobs are equivalent.Suppose that Rearden Metal's contract is certain,but Wyatt Oil has a 60% chance of going bankrupt at the end of the year.In the event that Wyatt Oil files for bankruptcy,it will cancel your contract and pay you the lowest amount possible for you to not quit.If you do quit,you expect you could find an new job paying $75,000 per year,but you would be unemployed for four months while searching for this new job.
-If you take the job with Wyatt Oil,then,in the event of bankruptcy,the least amount that Wyatt Oil would pay you next year is closest to:

Accepted Answer

A) $45,000 
B) $50,000 
C) $54,000 
D) $75,000 
A) $45,000 
B) $50,000 
C) $54,000 
D) $75,000 B

Question 3

Use the following information to answer the question(s)below.
d'Anconia Copper is considering issuing one year debt,and has come up with the following estimates of the value of the interest tax shield and the probability of distress for different levels of debt:  
-If in the event of distress,the present value of distress costs is equal to $10 million,then the optimal level of debt for d'Anconia Copper is:

Accepted Answer

A) $25 million 
B) $50 million 
C) $60 million 
D) $70 million 
A) $25 million 
B) $50 million 
C) $60 million 
D) $70 million C

Question 4

Which of the following statements is FALSE?

Accepted Answer

A) One disadvantage of using leverage is that it does not allow the original owners of the firm to maintain their equity stake. 
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) Managers also have their own personal interests,which may differ from those of both equity holders and debt holders. 
D) The costs of reduced effort and excessive spending on perks are another form of agency cost. 
A) One disadvantage of using leverage is that it does not allow the original owners of the firm to maintain their equity stake. 
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) Managers also have their own personal interests,which may differ from those of both equity holders and debt holders. 
D) The costs of reduced effort and excessive spending on perks are another form of agency cost.

Question 5

The cost of ________ is highest for firms that can easily increase the risk of their investments.

Accepted Answer

A) asset substitution 
B) debt overhang 
C) debt covenants 
D) debt maturity 
A) asset substitution 
B) debt overhang 
C) debt covenants 
D) debt maturity

Question 6

Use the information for the question(s)below.
Monsters Incorporated (MI)in ready to launch a new product.Depending upon the success of this product,MI will have a value of either $100 million,$150 million,or $191 million,with each outcome being equally likely.The cash flows are unrelated to the state of the economy (i.e.risk from the project is diversifiable)so that the project has a beta of 0 and a cost of capital equal to the risk-free rate,which is currently 5%.Assume that the capital markets are perfect.
-The initial value of MI's equity without leverage is closest to:

Accepted Answer

A) $133 million 
B) $147 million 
C) $140 million 
D) $150 million 
A) $133 million 
B) $147 million 
C) $140 million 
D) $150 million

Question 7

The cost of ________ is highest for firms that are likely to have profitable future growth opportunities requiring large investments.

Accepted Answer

A) asset substitution 
B) debt overhang 
C) debt covenants 
D) debt maturity 
A) asset substitution 
B) debt overhang 
C) debt covenants 
D) debt maturity

Question 8

Assume that in the event of default,20% of the value of MI's assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $140 million face value due next year.Calculate the value of levered equity,the value of debt,and the total value of MI with leverage.

Accepted Answer

V^L = @#IMG-DLM& = $19.37 million V_debt = @#IMG-DLM& =

Question 9

The term moral hazard refers to:

Accepted Answer

A) the chance the firm will default and impose losses on its debtholders. 
B) the under-investment problem. 
C) the over-investment problem. 
D) the idea that individuals will change their behavior if they are not fully exposed to its consequences. 
A) the chance the firm will default and impose losses on its debtholders. 
B) the under-investment problem. 
C) the over-investment problem. 
D) the idea that individuals will change their behavior if they are not fully exposed to its consequences.

Question 10

Which of the following statements is FALSE?

Accepted Answer

A) 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. 
B) The costs of financial distress represent an important departure from Modigliani and Miller's assumption of perfect capital markets. 
C) Levered firms risk incurring financial distress costs that reduce the cash flows available to investors. 
D) When securities are fairly priced,the original shareholders of a firm pay the future value of the costs associated with bankruptcy and financial distress. 
A) 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. 
B) The costs of financial distress represent an important departure from Modigliani and Miller's assumption of perfect capital markets. 
C) Levered firms risk incurring financial distress costs that reduce the cash flows available to investors. 
D) When securities are fairly priced,the original shareholders of a firm pay the future value of the costs associated with bankruptcy and financial distress.

Question 11

List five general categories of indirect costs associated with bankruptcy.

Accepted Answer

Indirect Costs:
Costs to Credi

Question 12

Assume that in the event of default,20% of the value of MI's assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face value due next year.The initial value of MI's equity is closest to:

Accepted Answer

A) $30 million 
B) $29 million 
C) $15 million 
D) $24 million 
A) $30 million 
B) $29 million 
C) $15 million 
D) $24 million

Question 13

Which of the following statements is FALSE?

Accepted Answer

A) Firms with high R&D costs and future growth opportunities typically maintain high debt levels. 
B) The tradeoff theory explains how firms should choose their capital structures to maximize value to current shareholders. 
C) 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. 
D) 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. 
A) Firms with high R&D costs and future growth opportunities typically maintain high debt levels. 
B) The tradeoff theory explains how firms should choose their capital structures to maximize value to current shareholders. 
C) 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. 
D) 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.

Question 14

Which of the following statements is FALSE?

Accepted Answer

A) 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. 
B) In addition to the money spent by the firm,the creditors may incur costs during the bankruptcy process. 
C) The bankruptcy code is designed to provide an orderly process for settling a firm's debts. 
D) 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. 
A) 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. 
B) In addition to the money spent by the firm,the creditors may incur costs during the bankruptcy process. 
C) The bankruptcy code is designed to provide an orderly process for settling a firm's debts. 
D) 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.

Question 15

The total debt overhang associated with accepting project 1,is closest to:

Accepted Answer

A) $0 million 
B) $12.5 million 
C) $14.4 million 
D) $22.5 million 
A) $0 million 
B) $12.5 million 
C) $14.4 million 
D) $22.5 million

Question 16

Use the information for the question(s)below.
Monsters Incorporated (MI)in ready to launch a new product.Depending upon the success of this product,MI will have a value of either $100 million,$150 million,or $191 million,with each outcome being equally likely.The cash flows are unrelated to the state of the economy (i.e.risk from the project is diversifiable)so that the project has a beta of 0 and a cost of capital equal to the risk-free rate,which is currently 5%.Assume that the capital markets are perfect.
-Suppose that MI has zero-coupon debt with a $140 million face value due next year.Calculate the value of levered equity,the value of debt,and the total value of MI with leverage.

Accepted Answer

V^L = @#IMG-DLM& = $19.37 million V_debt = @#IMG-DLM& =

Question 17

Assuming your cost of capital is 6 percent,based on the present value of your expected wage you should:

Accepted Answer

A) accept Rearden's offer since the PV of your expected wage would be approximately $6000 higher. 
B) accept Rearden's offer since the PV of your expected wage would be approximately $8000 lower. 
C) accept Rearden's offer since the PV of your expected wage would be approximately $8000 higher. 
D) accept Wyatt's offer since the PV of your expected wage would be approximately $6000 higher. 
A) accept Rearden's offer since the PV of your expected wage would be approximately $6000 higher. 
B) accept Rearden's offer since the PV of your expected wage would be approximately $8000 lower. 
C) accept Rearden's offer since the PV of your expected wage would be approximately $8000 higher. 
D) accept Wyatt's offer since the PV of your expected wage would be approximately $6000 higher.

Question 18

Use the information for the question(s)below.
Luther Industries has no debt and expects to generate free cash flows of $48 million each year.Luther believes that if it permanently increases its level of debt to $100 million,the risk of financial distress may cause it to lose some customers and receive less favorable terms from its suppliers.As a result,Luther's expected free cash flows with debt will be only $44 million per year.Suppose Luther's tax rate is 40%,the risk-free rate is 6%,the expected return of the market is 14%,and the beta of Luther's free cash flows is 1.25 (with or without leverage).
-The value of Luther without leverage is closest to:

Accepted Answer

A) $315 million 
B) $300 million 
C) $205 million 
D) $340 million 
A) $315 million 
B) $300 million 
C) $205 million 
D) $340 million

Question 19

Assume that capital markets are perfect except for the existence of corporate taxes and that your firm pays 40% of earnings in taxes.If you want to maintain ownership of at least a 50%,then the minimum amount of debt that you must issue to fund the expansion is closest to:

Accepted Answer

A) $19 million 
B) $18 million 
C) $16 million 
D) $20 million 
A) $19 million 
B) $18 million 
C) $16 million 
D) $20 million

Question 20

Which of the following statements is FALSE?

Accepted Answer

A) When a firm fails to make a required payment to debt holders,it is in bankruptcy. 
B) 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. 
C) 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. 
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. 
A) When a firm fails to make a required payment to debt holders,it is in bankruptcy. 
B) 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. 
C) 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. 
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.

Exam 16: Financial Distress,managerial Incentives,and Information

A type of agency problem that results in shareholders gaining by choosing not to finance new,positive-NPV projects is:

Which of the following statements is FALSE?

The cost of ________ is highest for firms that can easily increase the risk of their investments.

The cost of ________ is highest for firms that are likely to have profitable future growth opportunities requiring large investments.

Assume that in the event of default,20% of the value of MI's assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $140 million face value due next year.Calculate the value of levered equity,the value of debt,and the total value of MI with leverage.

The term moral hazard refers to:

Which of the following statements is FALSE?

List five general categories of indirect costs associated with bankruptcy.

Assume that in the event of default,20% of the value of MI's assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face value due next year.The initial value of MI's equity is closest to:

Which of the following statements is FALSE?

Which of the following statements is FALSE?

The total debt overhang associated with accepting project 1,is closest to:

Assuming your cost of capital is 6 percent,based on the present value of your expected wage you should:

Assume that capital markets are perfect except for the existence of corporate taxes and that your firm pays 40% of earnings in taxes.If you want to maintain ownership of at least a 50%,then the minimum amount of debt that you must issue to fund the expansion is closest to:

Which of the following statements is FALSE?

The Corporation

Introduction to Financial Statement Analysis

Financial Decision Making and the Law of One Price

The Time Value of Money

Interest Rates

Valuing Bonds

Investment Decision Rules

Fundamentals of Capital Budgeting

Valuing Stocks

Capital Markets and the Pricing of Risk

Optimal Portfolio Choice and the Capital Asset Pricing Model

Estimating the Cost of Capital

Investor Behavior and Capital Market Efficiency

Capital Structure in a Perfect Market

Debt and Taxes

Payout Policy

Capital Budgeting and Valuation With Leverage

Valuation and Financial Modeling: a Case Study

Financial Options

Option Valuation

Real Options

Raising Equity Capital

Debt Financing

Leasing

Working Capital Management

Short-Term Financial Planning

Mergers and Acquisitions

Corporate Governance

Risk Management

International Corporate Finance

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