Question 1

Which of the following statements is false?

Accepted Answer

A)  Creditors often place restrictions on the actions that the firm can take. Such restrictions are referred to as debt covenants. 
B)  Covenants are often designed to prevent management from exploiting debt holders, so they may help to reduce agency costs. 
C)  Agency costs are smallest for long-term debt. 
D)  Covenants may limit the firm's ability to pay large dividends or the types of investments that the firm can make. 
A)  Creditors often place restrictions on the actions that the firm can take. Such restrictions are referred to as debt covenants. 
B)  Covenants are often designed to prevent management from exploiting debt holders, so they may help to reduce agency costs. 
C)  Agency costs are smallest for long-term debt. 
D)  Covenants may limit the firm's ability to pay large dividends or the types of investments that the firm can make. C

Question 2

Assume that capital markets are perfect except for the existence of corporate taxes and that your firm pays 35% of earnings in taxes.If you want to maintain ownership of at least 50% of your firm,then calculate the minimum amount of debt that you must issue to fund the expansion.

Accepted Answer

V^U = $75 million
% Ownership =

V<sup>U</sup> = $75 million % Ownership = Given: V<sup>L = VU + τ</sup><sub>c</sub>D New equity = $50 million needed for expansion - the amount of new debt: % Ownership = % Ownership = = .50 (given we want 50% ownership) $25 + .35(debt)= .50($75 - .65(debt)) 50 + 1.35(debt)= 75 Debt = = $18.52 million

Given:
V^{L = VU + τ}_cD
New equity = $50 million needed for expansion - the amount of new debt:
% Ownership =

% Ownership =

= .50 (given we want 50% ownership)
$25 + .35(debt)= .50($75 - .65(debt))
50 + 1.35(debt)= 75
Debt =

= $18.52 million

Question 3

Economic distress represents a significant decline in the value of ________,whether or not it experiences financial distress due to leverage.

Accepted Answer

A)  a firm's liability 
B)  a firm's assets 
C)  a firm's equity 
D)  a firm's debts 
A)  a firm's liability 
B)  a firm's assets 
C)  a firm's equity 
D)  a firm's debts B

Question 4

Which of the following statements is false?

Accepted Answer

A)  The most important insight regarding capital structure goes back to Modigliani and Miller: with perfect capital markets, a firm's security choice alters the risk of the firm's equity, but it does not change its value or the amount it can raise from outside investors. 
B)  When agency costs are significant, short-term debt may be the most attractive form of external financing. 
C)  Too much debt can motivate managers and equity holders to take excessive risks or over-invest in a firm. 
D)  Of all the different possible imperfections that drive capital structure, the most clear-cut, and possibly the most significant, is taxes. 
A)  The most important insight regarding capital structure goes back to Modigliani and Miller: with perfect capital markets, a firm's security choice alters the risk of the firm's equity, but it does not change its value or the amount it can raise from outside investors. 
B)  When agency costs are significant, short-term debt may be the most attractive form of external financing. 
C)  Too much debt can motivate managers and equity holders to take excessive risks or over-invest in a firm. 
D)  Of all the different possible imperfections that drive capital structure, the most clear-cut, and possibly the most significant, is taxes.

Question 5

List five general categories of indirect costs associated with bankruptcy.

Accepted Answer

Indirect Costs:
Costs to Credi

Question 6

Which of the following statements is false?

Accepted Answer

A)  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. 
C)  Economic distress is a significant decline in the value of a firm's assets, whether or not it experiences financial distress due to leverage. 
D)  Modigliani and Miller's results continue to hold in a perfect market even when debt is risky and the firm may default. 
A)  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. 
C)  Economic distress is a significant decline in the value of a firm's assets, whether or not it experiences financial distress due to leverage. 
D)  Modigliani and Miller's results continue to hold in a perfect market even when debt is risky and the firm may default.

Question 7

Which of the following statements is false?

Accepted Answer

A)  Leverage can reduce the degree of managerial entrenchment because managers are more likely to be fired when a firm faces financial distress. 
B)  When a firm is highly levered, creditors themselves will closely monitor the actions of managers, providing an additional layer of management oversight. 
C)  According to the empire building hypothesis, leverage increases firm value because it commits the firm to making future interest payments, thereby reducing excess cash flows and wasteful investment by managers. 
D)  Managers of large firms tend to earn higher salaries, and they may also have more prestige and garner greater publicity than managers of small firms. As a result, managers may expand (or fail to shut down) unprofitable divisions, pay too much for acquisitions, make unnecessary capital expenditures, or hire unnecessary employees. 
A)  Leverage can reduce the degree of managerial entrenchment because managers are more likely to be fired when a firm faces financial distress. 
B)  When a firm is highly levered, creditors themselves will closely monitor the actions of managers, providing an additional layer of management oversight. 
C)  According to the empire building hypothesis, leverage increases firm value because it commits the firm to making future interest payments, thereby reducing excess cash flows and wasteful investment by managers. 
D)  Managers of large firms tend to earn higher salaries, and they may also have more prestige and garner greater publicity than managers of small firms. As a result, managers may expand (or fail to shut down) unprofitable divisions, pay too much for acquisitions, make unnecessary capital expenditures, or hire unnecessary employees.

Question 8

The agency costs are the costs that arise when there are conflicts of interest

Accepted Answer

A)  between management and shareholders. 
B)  between customers and suppliers. 
C)  between stakeholders. 
D)  between the board of directors and shareholders. 
A)  between management and shareholders. 
B)  between customers and suppliers. 
C)  between stakeholders. 
D)  between the board of directors and shareholders.

Question 9

Use the information for the question(s) below.
Big Blue Banana (BBB) is a clothing retailer with a current share price of $10.00 and with 25 million shares outstanding. Suppose that Big Blue Banana announces plans to lower its corporate taxes by borrowing $100 million and using the proceeds to repurchase shares.
-Suppose that BBB pays corporate taxes of 40% and that shareholders expect the change in debt to be permanent.Assume that capital markets are perfect except for the existence of corporate taxes and financial distress costs.If the price of BBB's stock rises to $10.80 per share following the announcement,then the present value of BBB's financial distress costs is closest to:

Accepted Answer

V^U = $10.00 × 25 million shares = $250 mi

Question 10

Which of the following statements is false?

Accepted Answer

A)  When a firm faces financial distress, shareholders have an incentive not to invest and to withdraw money from the firm if possible. 
B)  Because top managers often hold shares in the firm and are hired and retained with the approval of the board of directors, which itself is elected by shareholders, managers will generally make decisions that increase the value of the firm's equity. 
C)  An over-investment problem occurs when shareholders have an incentive to invest in risky positive-NPV projects. 
D)  A negative-NPV project destroys value for the firm overall. 
A)  When a firm faces financial distress, shareholders have an incentive not to invest and to withdraw money from the firm if possible. 
B)  Because top managers often hold shares in the firm and are hired and retained with the approval of the board of directors, which itself is elected by shareholders, managers will generally make decisions that increase the value of the firm's equity. 
C)  An over-investment problem occurs when shareholders have an incentive to invest in risky positive-NPV projects. 
D)  A negative-NPV project destroys value for the firm overall.

Question 11

Under the BIA,a firm may put forth a proposal that can either be accepted or rejected by its ________.

Accepted Answer

A)  creditors 
B)  provincial government 
C)  shareholders 
D)  stakeholders 
A)  creditors 
B)  provincial government 
C)  shareholders 
D)  stakeholders

Question 12

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 favourable 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 13

The idea that claims in one's self-interest are credible only if they are supported by actions that would be too costly to take if the claims were untrue is known as the

Accepted Answer

A)  pecking order hypothesis. 
B)  credibility principle. 
C)  lemons principle. 
D)  signaling theory of debt. 
A)  pecking order hypothesis. 
B)  credibility principle. 
C)  lemons principle. 
D)  signaling theory of debt.

Question 14

In many Canadian cases the actual ownership and exposure to the resources of the firm is ________ while the voting control is ________.This is accomplished by dominant shareholders (usually controlling families)that utilize super-voting shares,cross ownership,or pyramidal ownership structures.

Accepted Answer

A)  large; small 
B)  small; large 
C)  large; large 
D)  small; small 
A)  large; small 
B)  small; large 
C)  large; large 
D)  small; small

Question 15

Which of the following is NOT a direct cost of bankruptcy?

Accepted Answer

A)  Costs to Creditors 
B)  Investment Banking Costs 
C)  Costs of accounting experts 
D)  Legal Costs and Fees 
A)  Costs to Creditors 
B)  Investment Banking Costs 
C)  Costs of accounting experts 
D)  Legal Costs and Fees

Question 16

In aggregate,Canadian firms tend to issue debt ________ equity or trust units.

Accepted Answer

A)  less than 
B)  the same as 
C)  more than 
D)  none of the above 
A)  less than 
B)  the same as 
C)  more than 
D)  none of the above

Question 17

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 18

Which of the following is NOT an indirect cost of bankruptcy?

Accepted Answer

A)  Loss of Suppliers 
B)  Fire Sales of Assets 
C)  Costs of Appraisers 
D)  Loss of Employees 
A)  Loss of Suppliers 
B)  Fire Sales of Assets 
C)  Costs of Appraisers 
D)  Loss of Employees

Question 19

Use the information for the question(s) below.
Monsters Incorporated (MI) is 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.
-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 total value of MI with leverage is closest to:

Accepted Answer

A)  $140 million 
B)  $100 million 
C)  $125 million 
D)  $134 million 
A)  $140 million 
B)  $100 million 
C)  $125 million 
D)  $134 million

Question 20

Which of the following statements is false?

Accepted Answer

A)  Although indirect costs of bankruptcy are difficult to measure accurately, they are typically much smaller than the direct costs of bankruptcy. 
B)  Bankruptcy protection can be used by management to delay the liquidation of a firm that should be shut down. 
C)  Because many aspects of the bankruptcy process are independent of the size of the firm, the costs are typically higher, in percentage terms, for smaller firms. 
D)  Aside from the direct legal and administrative costs of bankruptcy, many other indirect costs are associated with financial distress (whether or not the firm has formally filed for bankruptcy). 
A)  Although indirect costs of bankruptcy are difficult to measure accurately, they are typically much smaller than the direct costs of bankruptcy. 
B)  Bankruptcy protection can be used by management to delay the liquidation of a firm that should be shut down. 
C)  Because many aspects of the bankruptcy process are independent of the size of the firm, the costs are typically higher, in percentage terms, for smaller firms. 
D)  Aside from the direct legal and administrative costs of bankruptcy, many other indirect costs are associated with financial distress (whether or not the firm has formally filed for bankruptcy).

Exam 19: Financial Distress, managerial Incentives, and Information

Which of the following statements is false?

Assume that capital markets are perfect except for the existence of corporate taxes and that your firm pays 35% of earnings in taxes.If you want to maintain ownership of at least 50% of your firm,then calculate the minimum amount of debt that you must issue to fund the expansion.

Economic distress represents a significant decline in the value of ________,whether or not it experiences financial distress due to leverage.

Which of the following statements is false?

List five general categories of indirect costs associated with bankruptcy.

Which of the following statements is false?

Which of the following statements is false?

The agency costs are the costs that arise when there are conflicts of interest

Which of the following statements is false?

Under the BIA,a firm may put forth a proposal that can either be accepted or rejected by its ________.

The idea that claims in one's self-interest are credible only if they are supported by actions that would be too costly to take if the claims were untrue is known as the

In many Canadian cases the actual ownership and exposure to the resources of the firm is ________ while the voting control is ________.This is accomplished by dominant shareholders (usually controlling families)that utilize super-voting shares,cross ownership,or pyramidal ownership structures.

Which of the following is NOT a direct cost of bankruptcy?

In aggregate,Canadian firms tend to issue debt ________ equity or trust units.

Which of the following statements is false?

Which of the following is NOT an indirect cost of bankruptcy?

Which of the following statements is false?

The Corporation

Introduction to Financial Statement Analysis

Arbitrage and Financial Decision Making

The Time Value of Money

Interest Rates

Valuing Bonds

Valuing Stocks

Investment Decision Rules

Fundamentals of Capital Budgeting

Capital Markets and the Pricing of Risk

Optimal Portfolio Choice and the Capital Asset Pricing Model

Estimating the Cost of Capital

Investor Behaviour and Capital Market Efficiency

Financial Options

Option Valuation

Real Options

Capital Structure in a Perfect Market

Debt and Taxes

Payout Policy

Capital Budgeting and Valuation With Leverage

Valuation and Financial Modelling: a Case Study

The Mechanics of Raising Equity Capital

Debt Financing

Leasing

Working Capital Management

Short-Term Financial Planning

Mergers and Acquisitions

Corporate Governance

Risk Management

International Corporate Finance

Filters

In many Canadian cases the actual ownership and exposure to the resources of the firm is while the voting control is .This is accomplished by dominant shareholders (usually controlling families)that utilize super-voting shares,cross ownership,or pyramidal ownership structures.