Deck 19: Financial Distress, managerial Incentives, and Information

Question 1

Canadian bankruptcy law was created to ensure that ________ are treated fairly and the value of the assets is not needlessly destroyed.

A) shareholders
B) stakeholders
C) creditors
D) owners

Answer 1

creditors

Question 2

As the case of Air Canada demonstrates,firms such as airlines whose future cash flows are unstable and highly sensitive to shocks in the economy run the risk of bankruptcy if they use ________ leverage.

A) zero
B) too little
C) too much
D) total

Answer 2

too much

Question 3

Which of the following statements is false?

A) Usually relatively larger companies use the BIA and liquidation is often the result.
B) Bankruptcy law is designed to provide an orderly process for settling a firm's debts.
C) Once the company has applied to the court for protection against its creditors, in the form of a stay, under the CCAA, all pending collection attempts are automatically suspended, and the firm's existing management is given the opportunity to propose a reorganization plan.
D) A notable difference between the CCAA and Chapter 11 of US Bankruptcy Reform Act is that under Chapter 11 the bankruptcy court can impose a plan even if not all creditor classes approve it.

Answer 3

Usually relatively larger companies use the BIA and liquidation is often the result.

Question 4

There are two relevant acts for financially distressed firms in Canada:

A) the Bankruptcy and Insolvency Act (BIA) and the Companies' Registration Act (CRA).
B) the Bankruptcy and Insolvency Act (BIA) and the Companies' Creditors Arrangement Act (CCAA).
C) the Canada Business Corporations Act (CBCA) and the Companies' Creditors Arrangement Act (CCAA).
D) the Canada Business Corporations Act (CBCA) and the Canada's Corporations Act (CCA).

Question 5

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

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

Question 6

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 $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.

Question 7

The BIA usually applies to ________ while the CCAA applies to firms that owe ________ to creditors.

A) small businesses; $1 million or less
B) big business; $1 million or less
C) small businesses; $5 million or more
D) big business; $5 million or more

Question 8

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:

A) 25.0%
B) 12.5%
C) 5.0%
D) 7.8%

Question 9

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.
The initial value of MI's equity without leverage is closest to:

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

Question 10

Which of the following statements is false?

A) The Canadian bankruptcy code was created to organize this process so that creditors are treated fairly and the value of the assets is not needlessly destroyed.
B) Because the assets of the firm might be more valuable if kept together, creditors seizing assets in a piecemeal fashion might destroy much of the remaining value of the firm.
C) Debt holders can then take legal action against the firm to collect payment by seizing the firm's assets.
D) Because most firms have multiple creditors, coordination makes it difficult to guarantee that each creditor will be treated fairly.

Question 11

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 yield to maturity of MI's debt is closest to:

A) 12.5%
B) 7.8%
C) 25.0%
D) 5.0%

Question 12

Use the information for the question(s) below.
Kinston Enterprises has no debt and a debt obligation of $47 million that is due now. The market value of Kinston's assets is $102 million, and the firm has no other liabilities. Assume that capital markets are perfect and that Kinston has 5 million shares outstanding.
Kinston's current share price is closest to:

A) $20.40
B) $9.40
C) $11.00
D) $10.00

Question 13

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 initial value of MI's equity is closest to:

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

Question 14

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 initial value of MI's debt is closest to:

A) $125 million
B) $111 million
C) $100 million
D) $116 million

Question 15

Which of the following statements is false?

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.

Question 16

Which of the following statements is false?

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 17

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:

A) $133 million
B) $140 million
C) $147 million
D) $125 million

Question 18

Use the information for the question(s) below.
Kinston Enterprises has no debt and a debt obligation of $47 million that is due now. The market value of Kinston's assets is $102 million, and the firm has no other liabilities. Assume that capital markets are perfect and that Kinston has 5 million shares outstanding.
The number of new shares that Kinston must issue to raise the capital needed to pay its debt obligation is closest to:

A) 4.3 million
B) 4.7 million
C) 5.0 million
D) 4.0 million

Question 19

Which of the following statements is false?

A) Equity holders expect to receive dividends and the firm is legally obligated to pay them.
B) A firm that fails to make the required interest or principal payments on the debt is in default.
C) In extreme cases, the debt holders take legal ownership of the firm's assets through a process called bankruptcy.
D) After a firm defaults, debt holders are given certain rights to the assets of the firm.

Question 20

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

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

Question 21

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:

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

Question 22

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

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

Question 23

List five general categories of indirect costs associated with bankruptcy.

Question 24

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

A) Legal Fees
B) Delayed Liquidation
C) Costs to Creditors
D) Loss of Customers

Question 25

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 initial value of MI's equity is closest to:

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

Question 26

Which of the following statements is false?

A) The costs of selling assets below their value are greatest for firms with assets that lack competitive, liquid markets.
B) Firms in financial distress tend to have difficulty collecting money that is owed to them.
C) Suppliers may be unwilling to provide a firm with inventory if they fear they will not be paid.
D) The loss of customers is likely to be large for producers of raw materials (such as sugar or aluminum), as the value of these goods, once delivered, depends on the seller's continued success.

Question 27

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.Suppose that at the start of the year,MI has no debt outstanding,but has 5.6 million shares of stock outstanding.If MI issues debt of $125 million due next year and uses the proceeds to repurchase shares,the share price following the announcement of the repurchase will be closest to:

A) $23.90
B) $23.75
C) $25.00
D) $5.15

Question 28

Which of the following statements is false?

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 29

Which of the following statements is false?

A) The direct costs of bankruptcy are likely to be higher for firms with more complicated business operations and for firms with larger numbers of creditors, because it may be more difficult to reach agreement among many creditors regarding the final disposition of the firm's assets.
B) In a prepackaged bankruptcy (or "prepack") a firm will first develop a reorganization plan with the agreement of its main creditors, and then file Chapter 7 to implement the plan and pressure any creditors who attempt to hold out for better terms.
C) A study of Chapter 7 liquidations of small businesses in the U.S. found that the average direct costs of bankruptcy were 12% of the value of the firm's assets.
D) Studies typically report that the average direct costs of bankruptcy are approximately 3% to 4% of the pre-bankruptcy market value of total assets.

Question 30

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.
Assuming that in the event of default,20% of the value of MI's assets will be lost in bankruptcy costs,the initial value of MI's equity without leverage is closest to:

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

Question 31

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 initial value of MI's debt is closest to:

A) $110 million
B) $105 million
C) $125 million
D) $111 million

Question 32

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.Suppose that at the start of the year,MI has no debt outstanding,but has 5.6 million shares of stock outstanding.If MI does not issue debt,its share price is closest to:

A) $5.15
B) $23.75
C) $23.90
D) $25.00

Question 33

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 yield to maturity of MI's debt is closest to:

A) 13.75%
B) 5.00%
C) 19.25%
D) 12.50%

Question 34

Which of the following statements is false?

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 35

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

A) the present value
B) the book value
C) the current value
D) the market value

Question 36

Which of the following statements is false?

A) According to the provisions of the 1978 Bankruptcy Reform Act, Canadian firms can file for two forms of bankruptcy protection: Chapter 11 or Chapter 13.
B) The Chapter 11 reorganization plan specifies the treatment of each creditor of the firm. In addition to cash payment, creditors may receive new debt or equity securities of the firm. The value of cash and securities is generally less than the amount each creditor is owed, but more than the creditors would receive if the firm were shut down immediately and liquidated.
C) In the more common form of bankruptcy for large corporations, Chapter 11 reorganization, all pending collection attempts are automatically suspended, and the firm's existing management is given the opportunity to propose a reorganization plan.
D) While developing a Chapter 11 reorganization plan, management continues to operate the business.

Question 37

Which of the following statements is false?

A) The creditors must vote to accept the Chapter 11 reorganization plan, and the bankruptcy court must approve it. If an acceptable plan is not put forth, the court may ultimately force a Chapter 7 liquidation of the firm.
B) In Chapter 13 liquidation, a trustee is appointed to oversee the liquidation of the firm's assets through an auction. The proceeds from the liquidation are used to pay the firm's creditors, and the firm ceases to exist.
C) When a corporation becomes financially distressed, outside professionals, such as legal and accounting experts, consultants, appraisers, auctioneers, and others with experience selling distressed assets are generally hired.
D) In the case of Chapter 11 reorganization, creditors must often wait several years for a reorganization plan to be approved and to receive payment.

Question 38

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

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

Question 39

Which of the following statements is false?

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).

Question 40

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 present value of MI's financial distress costs is closest to:

A) $20.0 million
B) $6.6 million
C) $6.3 million
D) $19.0 million

Question 41

Which of the following statements is false?

A) Real estate firms are likely to have low costs of financial distress, as much of their value derives from assets that can be sold relatively easily.
B) For low levels of debt, the risk of default remains low and the main effect of an increase in leverage is an increase in the interest tax shield, which has present value τ*D, where τ* is the effective tax advantage of debt.
C) Firms whose value and cash flows are very volatile (for example, semiconductor firms) must have much higher levels of debt to avoid a significant risk of default.
D) The probability of financial distress depends on the likelihood that a firm will be unable to meet its debt commitments and therefore default.

Question 42

Which of the following industries likely to have the highest costs of financial distress?

A) Grocery store
B) Semiconductors
C) Real estate
D) Utilities

Question 43

Which of the following statements is false?

A) When a firm faces financial distress, creditors can gain by making sufficiently risky investments, even if they have negative NPV.
B) When a firm has leverage, a conflict of interest exists if investment decisions have different consequences for the value of equity and the value of debt.
C) In some circumstances, managers may take actions that benefit shareholders but harm the firm's creditors and lower the total value of the firm.
D) Agency costs are costs that arise when there are conflicts of interest between stakeholders.

Question 44

Which of the following statements is false?

A) The tradeoff theory weighs the costs of debt that result from shielding cash flows from taxes against the benefits from the effects of financial distress associated with leverage.
B) Leverage has costs as well as benefits.
C) According to the tradeoff theory, the total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs.
D) Firms have an incentive to increase leverage to exploit the tax benefits of debt. But with too much debt, they are more likely to risk default and incur financial distress costs.

Question 45

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:

Question 46

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:

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

Question 47

Which of the following statements is false?

A) Firms with steady, reliable cash flows, such as utility companies, are able to use high levels of debt and still have a very low probability of default.
B) If there were no costs of financial distress, the value of the firm would continue to increase with increasing debt until the interest on the debt exceeds the firm's earnings before interest and taxes and the tax shield is exhausted.
C) The costs of financial distress reduce the value of the levered firm, V^L. The amount of the reduction decreases with the probability of default, which in turn increases with the level of the debt D.
D) The tradeoff theory states that firms should increase their leverage until it reaches the level D* for which V^L is maximized.

Question 48

The tradeoff theory weighs ________ of debt that result from shielding cash flows from taxes against the costs of financial distress associated with leverage.

A) the benefits
B) the costs
C) the interests
D) the terms

Question 49

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.
Assuming perfect capital markets,the share price for BBB after this announcement is closest to:

A) $11.40
B) $10.85
C) $10.00
D) $8.60

Question 50

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 35% 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 $10.85 per share following the announcement,then the present value of BBB's financial distress costs is closest to:

A) $21.25 million
B) $35.00 million
C) $11.40 million
D) $13.75 million

Question 51

Which of the following statements is false?

A) The presence of financial distress costs can explain why firms choose debt levels that are too high to fully exploit the interest tax shield.
B) With higher costs of financial distress, it is optimal for the firm to choose lower leverage.
C) Differences in the magnitude of financial distress costs and the volatility of cash flows can explain the differences in the use of leverage across industries.
D) At the point D*, where V^L is maximized, the tax savings that result from increasing leverage are just offset by the increased probability of incurring the costs of financial distress.

Question 52

An over-investment problem means that shareholders have an incentive to invest in risky ________ projects.

A) positive-NPV
B) negative-NPV
C) zero-NPV
D) none of the above

Question 53

Which of the following industries is likely to have the lowest costs of financial distress?

A) Airline
B) Computer Software
C) Biotechnology
D) Electric Utilities

Question 54

Two key qualitative factors determine ________ of financial distress costs: (1)the probability of financial distress and (2)the magnitude of the costs after a firm is in distress.

A) the market value
B) the book value
C) the future value
D) the present value

Question 55

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

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

Question 56

An under-investment problem suggests that shareholders choose to not invest in a ________ project.

A) zero-NPV
B) negative-NPV
C) positive-NPV
D) none of the above

Question 57

Which of the following statements is false?

A) Calculating the precise present value of financial distress costs is a relatively straightforward process.
B) Two key qualitative factors determine the present value of financial distress costs: (1) the probability of financial distress and (2) the magnitude of the costs after a firm is in distress.
C) Technology firms are likely to incur high costs when they are in financial distress due to the potential for loss of customers and key personnel, as well as a lack of tangible assets that can be easily liquidated.
D) The magnitude of the financial distress costs will depend on the relative importance of the sources of these costs and is likely to vary by industry.

Question 58

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.

Question 59

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 with leverage is closest to:

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

Question 60

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 35% and that shareholders expect the change in debt to be permanent.Assuming that capital markets are perfect except for the existence of corporate taxes,the share price for BBB after this announcement is closest to:

A) $10.00
B) $10.85
C) $8.60
D) $11.40

Question 61

Rose Industries has a $20 million loan due at the end of the year and its assets will have a market value of only $15 million when the loan comes due.Currently Rose has $2 million in cash.Rose is considering two possible alternative uses for this cash.One possibility is to pay the $2 million out to shareholders in the form of a special dividend.The second possibility is to invest the $2 million into a project that offers a $4 million NPV.What are the payoffs to the debt and equity holders under each of the two alternatives? Which alternative would equity holders prefer? Which alternative would debt holders prefer? What is the economic term that describes this situation?

Question 62

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?

A) $210 million
B) $275 million
C) $85 million
D) $160 million

Question 63

Which of the following statements is false?

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 64

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 expected payoff to debt holders with the speculative oil lease deal?

A) $10 million
B) $275 million
C) $85 million
D) $160 million

Question 65

Which of the following statements is false?

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 66

When Air Canada was in the process of reorganizing under the CCAA in 2003-2004,it was able to win wage concessions from its powerful unions by explaining that ________,if continued,would push Air Canada into bankruptcy.

A) the high agency cost
B) the high leasing cost
C) the high variable cost
D) the high cost structure

Question 67

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 overall expected payoff under JR's new riskier business strategy?

A) $4 million
B) $11 million
C) $20 million
D) $15 million

Question 68

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 and that your firm pays 40% of earnings in taxes.If you want to maintain ownership of at least 50% of your firm,then the minimum amount of debt that you must issue to fund the expansion is closest to:

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

Question 69

Which of the following statements is false?

A) A serious concern for large corporations is that managers may make large, unprofitable investments.
B) While overspending on personal perks may be a problem for large firms, these costs are likely to be small relative to the overall value of the firm.
C) Some financial economists explain a manager's willingness to engage in negative-NPV investments as empire building.
D) While ownership is often diluted for small, young firms, ownership typically becomes concentrated over time as a firm grows.

Question 70

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 $25 million in new debt,and you issue $25 million in new equity.Your ownership stake in the firm following these new issues of debt and equity is closest to:

A) 50%
B) 55%
C) 58%
D) 33%

Question 71

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:

A) 58%
B) 55%
C) 33%
D) 50%

Question 72

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.

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

Question 73

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 expected payoff to equity holders with the speculative oil lease deal?

A) $10 million
B) $160 million
C) $275 million
D) $135 million

Question 74

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?

A) $15 million
B) $11 million
C) $20 million
D) $4 million

Question 75

Which of the following statements is false?

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.

Question 76

Banks are generally opposed to high capital requirements. Moral hazard may partially explain why because

A) subsidies and bailouts reduce the risks associated with a high leverage position.
B) high leverage increases the bank's ability to benefit from the tax shield.
C) imposed high capital requirements impedes the efficient operation of capital markets.
D) imposed high capital requirements impedes the banks ability to use retained earnings to fund capital initiatives.

Question 77

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?

A) $20 million
B) $4 million
C) $15 million
D) $11 million

Question 78

Which of the following statements is false?

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 79

Which of the following statements is false?

A) The agency costs of debt can arise only if there is no chance the firm will default and impose losses on its debt holders.
B) Agency costs represent another cost of increasing the firm's leverage that will affect the firm's optimal capital structure choice.
C) An under-investment problem occurs when shareholders choose to not invest in a positive-NPV project.
D) When a firm faces financial distress, it may choose not to finance new, positive-NPV projects.

Question 80

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:

A) 58%
B) 50%
C) 33%
D) 55%