Exam 19: Financial Distress, managerial Incentives, and Information

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. -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:

Which of the following statements is false?

Which of the following statements is false?

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

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. -Suppose that MI has zero-coupon debt with a $125 million face value due next year.The expected return of MI's debt is closest to:

Which of the following statements is false?

The idea that when a seller has private information about the value of good,buyers will discount the price they are willing to pay due to adverse selection is known as the

Use the information for the question(s) below. JR Industries has a $20 million loan due at the end of the year and under its current business strategy its assets will have a market value of only $15 million when the loan comes due. JR is considering a new, much riskier business strategy. While this new, riskier strategy can be implemented using JR's existing assets without any additional investment, the new strategy has only a 40% probability of succeeding. If the new strategy is a success, the market value of JR's assets will be $30 million, but if the strategy fails the assets will be worth only $5 million. -What is the expected payoff to debt holders under JR's new riskier business strategy?

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.

Use the information for the question(s) below. Wildcat Drilling is an oil and gas exploration company that is currently operating two active oil fields with a market value of $200 million dollars each. Unfortunately, Wildcat Drilling has $500 million in debt coming due at the end of the year. A large oil company has offered Wildcat drilling a highly speculative, but potentially very valuable, oil and gas lease in exchange for one of their active oil fields. If Wildcat accepts the trade, there is a 10% chance that Wildcat will discover a major new oil field that would be worth $1.2 billion, a 15% chance that Wildcat will discover a productive oil field that would be worth $600 million, and a 75% chance that Wildcat will not discover any oil at all. -What is the overall expected payoff to Wildcat from the speculative oil lease deal?

Which of the following statements is false?

When securities are fairly priced,the original shareholders of a firm pay ________ of the costs associated with bankruptcy and financial distress.

Which of the following statements is false?

Use the information for the question(s) below. JR Industries has a $20 million loan due at the end of the year and under its current business strategy its assets will have a market value of only $15 million when the loan comes due. JR is considering a new, much riskier business strategy. While this new, riskier strategy can be implemented using JR's existing assets without any additional investment, the new strategy has only a 40% probability of succeeding. If the new strategy is a success, the market value of JR's assets will be $30 million, but if the strategy fails the assets will be worth only $5 million. -What is the expected payoff to equity holders under JR's new riskier business strategy?

Use the information for the question(s) below. You own your own firm and you need to raise $50 million to fund an expansion. Following the expansion, your firm will be worth $75 million in its unlevered form. You want to go ahead with the expansion, but you are concerned that you may not be able to maintain ownership of over 50% of your firm's equity. In other words, you are concerned that if you use equity to finance the expansion, you may lose control of your firm. -Assume that capital markets are perfect,you issue $30 million in new debt,and you issue $20 million in new equity.Your ownership stake in the firm following these new issues of debt and equity is closest to:

Use the information for the question(s) below. You own your own firm and you need to raise $50 million to fund an expansion. Following the expansion, your firm will be worth $75 million in its unlevered form. You want to go ahead with the expansion, but you are concerned that you may not be able to maintain ownership of over 50% of your firm's equity. In other words, you are concerned that if you use equity to finance the expansion, you may lose control of your firm. -Assume that capital markets are perfect except for the existence of corporate taxes.Your firm pays 40% of earnings in taxes and you decide to issue $25 million in new debt and $25 million in new equity.Your ownership stake in the firm following these new issues of debt and equity is closest to:

Which of the following statements is false?

Use the information for the question(s) below. If it is managed efficiently, Luther Industries will have assets with a market value of $100 million, $300, million, or $500 million next year, with each outcome being equally likely. Managers may, instead, engage in wasteful empire building which will reduce the firm's market value by $20 million in all cases. Managers may also increase the risk of the firm, changing the probability of each outcome to 50%, 20%, and 30% respectively. -If its managers engage in empire building,then the expected market value of Luther's assets is closest to:

According to the management entrenchment theory of capital structure,managers choose a capital structure to avoid the discipline of debt and to maintain their own job security.Thus,managers seek to ________ to prevent the job loss that would accompany financial distress.