Question 1

Foregone profitable projects due to debt restrictions is an indirect cost of bankruptcy.

Accepted Answer

Foregone profitable projects due to debt restrictions are considered an indirect cost of bankruptcy because they represent lost opportunities and reduced investment in potentially profitable ventures as a result of the company's financial distress and limitations imposed by creditors.

Question 2

In order to avoid bankruptcy, management sometimes seeks to work with creditors. One method of restructuring debt involves composition, which involves a reduction in the amount of the payment to be made.

Accepted Answer

Composition is a method of debt restructuring where the debtor and creditors agree on a reduced amount of payment, allowing the debtor to avoid bankruptcy by making more manageable payments.

Question 3

According to the absolute priority rule, the correct order of distribution in liquidation is:
Administrative expenses of the bankruptcy, Employee wages, Government taxes Unsecured creditors.

Accepted Answer

The absolute priority rule in bankruptcy establishes the order in which claims are paid from the liquidated assets of a bankrupt company. It prioritizes paying administrative expenses of the bankruptcy first, followed by employee wages, government taxes, and finally, unsecured creditors. This ensures that the costs of administering the bankruptcy are covered before any other claims and that employees and the government are paid before general unsecured claims.

Question 4

Loss of key employees is an indirect cost of bankruptcy.

Accepted Answer

Loss of key employees is considered an indirect cost of bankruptcy because it does not directly relate to the financial transactions or legal proceedings of the bankruptcy process, but rather results from the uncertainty and operational disruptions that bankruptcy can cause.

Question 5

When a firm is operating with the optimal capital structure, the debt-equity ratio will also be optimal.

Accepted Answer

The optimal capital structure is the mix of debt and equity financing that minimizes a firm's cost of capital and maximizes its value, thus making the debt-equity ratio optimal as well.

Question 6

It has been observed that, when firms get into financial trouble, they often find it difficult to attract and retain high-quality employees. The additional costs incurred in this situation would be considered direct bankruptcy costs.

Accepted Answer

The additional costs incurred in attracting and retaining high-quality employees when a firm is in financial trouble are considered indirect bankruptcy costs, not direct. Direct bankruptcy costs are those expenses that are directly associated with the bankruptcy process, such as legal and administrative fees.

Question 7

Direct bankruptcy costs are those costs that are directly associated with bankruptcy, such as legal and administrative costs.

Accepted Answer

Direct bankruptcy costs include all expenses that are directly related to the bankruptcy process, such as legal fees, accounting fees, and other administrative costs incurred during the bankruptcy proceedings.

Question 8

An unlevered firm has a cost of capital of 16% and earnings before interest and taxes of $225,000. A levered firm with the same operations and assets has both a book value and a face value of debt of $850,000 with an 8% annual coupon. The applicable tax rate is 34%. What is the value of the levered firm?

Accepted Answer

The answer of An unlevered firm has a cost of...

Question 9

All else the same, bankruptcy claims on the cash flows of the firm will tend to increase with decreases in the debt/equity ratio?

Accepted Answer

Bankruptcy claims on the cash flows of the firm tend to increase with increases in the debt/equity ratio, as higher debt levels relative to equity increase financial leverage and the risk of default.

Question 10

When a firm is operating with the optimal capital structure, the increased benefit from additional debt is equal to the increased bankruptcy costs of that debt.

Accepted Answer

At the optimal capital structure, the marginal benefit of debt (such as tax shields) is exactly offset by the marginal cost (such as increased bankruptcy risk), leading to a balance where the firm's value is maximized.

Question 11

The actual firm value is equal to the M&M Proposition I with tax value minus the financial distress costs.

Accepted Answer

M&M Proposition I with taxes states that the value of a leveraged firm is equal to the value of an unleveraged firm plus the tax shield on debt, but financial distress costs reduce this value.

Question 12

When a firm is operating with the optimal capital structure, the required return on assets will be at its maximum point.

Accepted Answer

When a firm is operating with the optimal capital structure, it minimizes its weighted average cost of capital (WACC) and maximizes its value, not the required return on assets.

Question 13

Accounting and legal fees incurred in the bankruptcy process is an indirect cost of bankruptcy.

Accepted Answer

Accounting and legal fees incurred in the bankruptcy process are considered direct costs of bankruptcy, as they are directly associated with the process of filing for and going through bankruptcy.

Question 14

Loss created by sale of assets which was required to improve liquidity is an indirect cost of bankruptcy.

Accepted Answer

This loss is considered an indirect cost because it's a consequence of the financial distress leading to bankruptcy, not a direct cost like legal fees, but still results from the need to address liquidity issues.

Question 15

All else the same, bondholder claims on the cash flows of the firm will tend to increase with decreases in the debt/equity ratio?

Accepted Answer

Bondholder claims on the cash flows of the firm are related to the amount of debt a firm has issued, not directly to the debt/equity ratio. Decreasing the debt/equity ratio often involves reducing debt or increasing equity, which would not increase bondholders' claims on cash flows; it might actually reduce the total amount of debt outstanding, thereby potentially reducing bondholders' claims.

Question 16

Joe's BBQ Grill has $21,000 of debt outstanding that is selling at par and has a coupon rate of 6.5%. The tax rate is 35%. What is the present value of the tax shield?

Accepted Answer

The answer of Joe's BBQ Grill has $21,000 of debt...

Question 17

A firm has a tax rate of 35%, an unlevered rate of return of 14%, total debt of $1,000, and an EBIT of $300.00. What is the unlevered value of the firm?

Accepted Answer

The unlevered value of the firm can be calculated using the formula: Unlevered Value = EBIT(1 - Tax Rate) / Unlevered Rate of Return. Plugging in the given values: Unlevered Value = $300(1 - 0.35) / 0.14 = $195 / 0.14 = $1,392.86, which rounds to $1,393.

Question 18

According to the absolute priority rule, the correct order of distribution in liquidation is:

Employee wages, Administrative expenses of the bankruptcy, Government taxes Unsecured creditors

Accepted Answer

The absolute priority rule dictates that secured creditors are paid first, followed by administrative expenses, employee wages, government taxes, and then unsecured creditors.

Question 19

Indirect bankruptcy costs include the costs of avoiding a bankruptcy filing incurred by a financially distressed firm.

Accepted Answer

Indirect bankruptcy costs refer to the various non-legal or procedural costs that a company faces when it is in financial distress, including efforts to avoid filing for bankruptcy, such as restructuring debts, losing customers, suppliers, or employees due to uncertainty, and the overall impact on business operations.

Question 20

When a firm files for bankruptcy, the firm often must hire appraisers to determine the fair value of the firm's assets. This is an example of a direct cost of bankruptcy.

Accepted Answer

Direct costs of bankruptcy include legal and administrative expenses, such as hiring appraisers to value the firm's assets, which are necessary for the bankruptcy process.

Quiz 16: Financial Leverage and Capital Structure Policy