Question 1

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 2

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 answer of According to the absolute priority rule, the...

Question 3

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

Direct bankruptcy costs refer to the explicit costs associated with the legal and administrative process of bankruptcy, such as legal fees and court costs. The difficulty in attracting and retaining employees is considered an indirect bankruptcy cost, as it affects the firm's operations and performance but is not a direct expense of the bankruptcy process itself.

Question 4

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

Bondholders have priority claims on the cash flows of the firm over equity holders. Therefore, as the debt/equity ratio decreases, the proportion of cash flows available for bondholders also decreases, reducing their claims on the cash flows of the firm.

Question 5

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 decrease with decreases in the debt/equity ratio.

Question 6

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 states that in liquidation, administrative expenses of the bankruptcy are paid first, followed by employee wages and government taxes. After that, unsecured creditors are paid in order of priority outlined by bankruptcy laws. This order may vary depending on the jurisdiction and type of bankruptcy case.

Question 7

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?
A) $478
B) $790
C) $1,365
D) $4,780
E) $7,350

Accepted Answer

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

Question 8

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

Accepted Answer

Foregone profitable projects due to debt restrictions result in lost opportunities for a company and can be considered an indirect cost of bankruptcy.

Question 9

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

Accepted Answer

This is because the optimal capital structure is achieved when the cost of capital is minimized and the value of the firm is maximized, and this typically occurs when debt and equity are balanced in the right proportions. Therefore, the debt-equity ratio will also be optimal.

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

The optimal capital structure is achieved when the marginal benefit of debt equals the marginal cost, including bankruptcy costs.

Question 11

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

Accepted Answer

When a company sells its assets to improve liquidity, it incurs a loss which is an indirect cost of bankruptcy as it could have been avoided if the company had better financial management and did not face the risk of bankruptcy.

Question 12

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?
A) $27
B) $393
C) $1,027
D) $1,393
E) $2,143

Accepted Answer

The answer of A ﬁrm has a tax rate of...

Question 13

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

This statement is true. Appraisers are typically hired to determine the fair value of a firm's assets during the bankruptcy process, and this cost is considered a direct cost of bankruptcy.

Question 14

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

Accepted Answer

The optimal capital structure is the one that minimizes the cost of capital or maximizes the value of the firm. This does not necessarily mean that the required return on assets will be at its maximum point. It means that the company's cost of capital is minimized by finding the right mix of debt and equity financing.

Question 15

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 costs incurred by a financially distressed firm in order to avoid a bankruptcy filing, such as legal fees, financial advisory fees, and other costs associated with restructuring or refinancing.

Question 16

Loss of key employees is an indirect cost of bankruptcy.

Accepted Answer

When a company goes bankrupt, it can lead to a loss of key employees who may seek employment elsewhere. This is an indirect cost of bankruptcy as it may lead to a loss of institutional knowledge and difficulty in retaining replacements for these key employees.

Question 17

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

Accepted Answer

Direct bankruptcy costs refer to the costs that arise specifically because of the bankruptcy process, such as legal fees, court fees, and administrative expenses.

Question 18

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 involves negotiating with creditors to reduce the amount owed and the payments to be made. This is a common method used by companies to avoid bankruptcy.

Question 19

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?
A) $928,125
B) $1,110,125
C) $1,178,125
D) $1,217,125
E) $1,778,125

Accepted Answer

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

Question 20

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

Accepted Answer

This statement is true. According to M&M Proposition I with tax, the firm value is equal to the value of an unlevered firm plus the tax shield from debt. However, financial distress costs must be subtracted from this value to arrive at the actual firm value.

Quiz 16: Financial Leverage and Capital Structure Policy

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

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

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.

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

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

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.

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?

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

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

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.

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

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?

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.

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

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

Loss of key employees is an indirect cost of bankruptcy.

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

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.

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