Question 1

Which of the following is NOT one of the six fundamental factors that determine the optimal source of debt funding for a firm?&#10;A)the firm's debt ratio&#10;B)lender's need to monitor the borrower's operations&#10;C)information asymmetry, and specifically the problem of assessing creditworthiness&#10;D)the firm's need for flexibility

Accepted Answer

The firm's debt ratio is not listed among the six fundamental factors determining the optimal source of debt funding. The factors typically include considerations like the cost of debt, the need for flexibility, the maturity of the debt, the need for monitoring by lenders, information asymmetry, and the strategic alignment of the debt with the firm's goals, but not the firm's debt ratio as a fundamental factor in the decision-making process.

Question 2

According to the ______principal, short-term assets should be financed with short-term capital and long-term assets with long-term capital.&#10;A)maturity matching&#10;B)hedging&#10;C)risk-return&#10;D)capital asset

Accepted Answer

The maturity matching principle suggests that the duration of assets and liabilities should be matched, meaning short-term assets should be financed with short-term capital and long-term assets with long-term capital. This helps in managing liquidity and interest rate risk.

Question 3

Suppose a firm wants to borrow $200 million for 5 years to fund capital expenditures, and is considering the choice of a bank loan or a public issue through an investment banking firm as underwriter.For simplicity, we will assume that in either case the firm will issue pure-discount debt.The bank demands a 10.25% interest rate (with no fee), while the underwriter states that the interest cost will be 9.25 percent with 3% flotation costs.Which funding source provides the lower effective interest cost?

A)the bank loan
B)the public issue
C)both provide exactly the same effective interest cost

the public issue

Accepted Answer

The effective interest cost of the bank loan is 10.25%, while the effective interest cost of the public issue is 9.25% * (1 + 3%) = 9.53%. Therefore, the public issue provides the lower effective interest cost.

Question 4

Monitoring is one means by which creditors can control a borrower's incentive to expropriate wealth from the creditors.However, direct monitoring of a borrower's actions is more difficult in a public bond issue than in a private bond issue because of the:

A)free-rider problem.
B)requirement of registration with the SEC for a public bond issue.
C)moral hazard problem.
D)adverse selection problem.

Accepted Answer

The free-rider problem makes direct monitoring more difficult in public bond issues because individual investors rely on others to monitor the borrower, leading to underinvestment in monitoring efforts.

Question 5

The value of a convertible bond is relatively insensitive to changes in the riskiness of the firm, because the value of the underlying bond is inversely related to changes in the firm's risk, while the value of the implicit call option is directly related to changes in the firm's risk.Consequently, with a convertible bond the firm's management no longer has an incentive to engage in ______to expropriate value from the bondholders, and therefore one of the major agency problems associated with debt is resolved.

A)excessive consumption of perquisites.
B)risk shifting.
C)excessive dividend payments.
D)excessively conservative investment policies.

Accepted Answer

The value of a convertible bond is less sensitive to changes in the firm's risk because the bond component loses value as risk increases (due to higher default risk), while the value of the conversion option (to convert the bond into equity) increases with higher risk (since equity holders benefit from increased volatility). This balance reduces the incentive for management to engage in risk shifting, which is taking on additional risk in an attempt to increase the firm's value at the expense of bondholders.

Question 6

A firm wants to borrow $100 million for 5 years (pure discount, for simplicity).Which of the following sources has the lower effective interest cost?
$\begin{array}{l}&&\text { Orig, Fee' }\\\text { Source } & \text { Interest Rate } & \text { Flotation Cost } \\\hline \text { Private Placement } & 9.00 \% & 1 \% \\\text { Public Issue } & 8.25 \% & 3 \%\end{array}$

A)The private placement
B)The public issue
C)The costs are the same

Accepted Answer

The effective interest cost is the annual interest rate that would have the same present value as the actual interest payments and flotation costs. For the private placement, the effective interest cost is:$$9.00\% + 1.00\% / 5 = 9.20\%$$For the public issue, the effective interest cost is:$$8.25\% + 3.00\% / 5 = 8.85\%$$Therefore, the public issue has the lower effective interest cost.

Question 7

Which of the following is the fundamental difference between private (bank) debt and publicly issued debt?&#10;A)Public debt is often referred to as inside debt because of the close relationship between the lenders and the borrower, while a bank loan is called outside debt because the lender essentially has no active relationship with the borrower.&#10;B)A bank loan is often referred to as inside debt because of the close relationship between lender and borrower, while public debt is called outside debt because the lenders essentially have no active relationship with the borrower.

Accepted Answer

Public debt is considered "outside debt" because it involves borrowing from the public or external entities where the relationship between the borrower (often a government) and the lenders (the public or investors) is not as close or direct. In contrast, a bank loan is "inside debt" due to the closer, more direct relationship between the borrower and the lender (the bank).

Deck 15: Corporate Liabilities: Strategic Selections of Lenders and Contract Terms