Question 1

Which one of the following statements is correct concerning a Chapter 7 bankruptcy?
A)A firm in Chapter 7 bankruptcy is reorganizing its operations such that is can return to being a viable concern.
B)Under a Chapter 7 bankruptcy, a trustee will assume control of the firm's assets until those assets can be liquidated.
C)Chapter 7 bankruptcies are always involuntary on the part of the firm.
D)Under a Chapter 7 bankruptcy, the claims of creditors are paid prior to the administrative costs of the bankruptcy.
E)Chapter 7 bankruptcy allows a firm to restructure its equity position such that new shares of stock are generally issued prior to the firm coming out of bankruptcy.

Accepted Answer

In a Chapter 7 bankruptcy, a trustee will be appointed to assume control of the firm's assets and liquidate them to pay off the claims of creditors. The goal of Chapter 7 bankruptcy is not to reorganize the firm, but rather to liquidate its assets and distribute the proceeds to creditors. The other options are incorrect as they do not accurately describe Chapter 7 bankruptcy.

Question 2

The costs of avoiding a bankruptcy filing by a financially distressed firm are classified as _____ costs.
A)capital structure
B)direct bankruptcy
C)financial solvency
D)indirect bankruptcy
E)flotation

Accepted Answer

Indirect bankruptcy costs refer to the costs of avoiding a bankruptcy filing by a financially distressed firm, such as legal fees, restructuring costs, and lost business opportunities.

Question 3

The optimal capital structure will tend to include more debt for firms with:
A)less taxable income.
B)lower probability of financial distress.
C)substantial tax shields from other sources.
D)the lowest marginal tax rate.
E)the highest depreciation deductions.

Accepted Answer

B

Question 4

The legal proceeding for liquidating or reorganizing a firm operating in default is called a:
A)tender offer.
B)bankruptcy.
C)merger.
D)takeover.
E)proxy fight.

Accepted Answer

Bankruptcy is the legal process for liquidating or reorganizing a firm that is operating in default. Tender offer, merger, takeover, and proxy fight are not specific to a defaulting firm and may not involve legal proceedings related to default.

Question 5

In general,the capital structures used by U.S.firms:
A)vary significantly across industries.
B)are easily explained in terms of earnings volatility.
C)are easily explained by analyzing the types of assets owned by the various firms.
D)tend to be those which maximize the use of the firm's available tax shelters.
E)tend to overweight debt in relation to equity.

Accepted Answer

Capital structures vary significantly across industries due to factors such as industry regulations, level of competition, and availability and cost of capital. Therefore, it is difficult to generalize the capital structures of U.S. firms based solely on their earnings volatility or asset types owned. Tax shelters may play a role in the decision-making process, but it is not the primary factor that drives the capital structure of most firms. Additionally, the use of debt and equity in a capital structure is dependent on individual firm's risk tolerance, growth potential, and profitability, and may not necessarily overweight debt in relation to equity.

Question 6

A firm is technically insolvent when:
A)the value of its stock declines by more than 50%.
B)the value of the firm's assets is less than the value of the firm's liabilities.
C)it files the legal forms petitioning for bankruptcy protection.
D)it is unable to meet its financial obligations.
E)it has a negative net worth on its balance sheet.

Accepted Answer

The answer of A firm is technically insolvent when:
A)the value...

Question 7

Indirect bankruptcy costs:
A)effectively limit the amount of equity a firm issues.
B)serve as an incentive to increase the financial leverage of a firm.
C)include the costs incurred by a firm as it tries to avoid seeking bankruptcy protection.
D)tend to increase as the debt-equity ratio decreases.
E)include direct costs such as legal and accounting fees.

Accepted Answer

Indirect bankruptcy costs include any costs incurred by a firm as it tries to avoid bankruptcy, such as the cost of restructuring or negotiating with creditors. These costs can be significant and can also include the loss of customers, suppliers, and employees. Indirect bankruptcy costs can be a powerful incentive for firms to avoid bankruptcy and to maintain a healthy financial position.

Question 8

In a world with taxes and financial distress,when a firm is operating with the optimal capital structure:
I.the debt-equity ratio will also be optimal.
II.the weighted average cost of capital will be at its minimal point.
III.the required return on assets will be at its maximum point.
IV.the increased benefit from additional debt is equal to the increased bankruptcy costs of that debt.
A)I and IV only
B)II and III only
C)I and II only
D)II, III, and IV only
E)I, II, and IV only

Accepted Answer

When a firm is operating with the optimal capital structure, it means that the firm has achieved the ideal balance between debt and equity in their financing. This leads to the following outcomes:
I. The debt-equity ratio will also be optimal as it is a part of achieving the ideal balance. 
II. The weighted average cost of capital will be at its minimal point as the firm has found the sweet spot in their financing where the overall cost of capital is minimized.
III. The required return on assets will be at its maximum point as the firm has taken on the appropriate amount of debt and is using it to generate the maximum amount of returns on assets.
IV. The increased benefit from additional debt is equal to the increased bankruptcy costs of that debt as the firm has found the optimal level of debt that maximizes the benefits while minimizing the risks.

Therefore, the correct answer is E, I, II, and IV only.

Question 9

Corporations in the U.S.tend to:
A)have extremely high debt-equity ratios.
B)rely less on equity financing than they should.
C)underutilize debt.
D)maximize taxes.
E)rely more heavily on bonds than stocks as the major source of financing.

Accepted Answer

Corporations in the U.S. tend to underutilize debt, meaning they rely less on borrowing and more on equity financing. This is due to reasons such as the fear of bankruptcy, the cost of borrowing, and the desire to maintain control of the company. As a result, their debt-equity ratios tend to be lower than those in other countries.

Question 10

The optimal capital structure has been achieved when the:
A)weight of equity is equal to the weight of debt.
B)debt-equity ratio is equal to 1.
C)debt-equity ratio selected results in the lowest possible weighted average cost of capital.
D)debt-equity ratio is such that the cost of debt exceeds the cost of equity.
E)cost of equity is maximized given a pre-tax cost of debt.

Accepted Answer

The optimal capital structure is achieved when the debt-equity ratio selected results in the lowest possible weighted average cost of capital (WACC). This means that the company is using the right amount of debt and equity financing to minimize its overall cost of capital. A debt-equity ratio of 1 (option B) may not necessarily result in the lowest WACC, and options A, D, and E do not consider the overall cost of capital.

Question 11

An attempt to financially restructure a failing firm so that it can continue operating as a going concern is called a:
A)merger.
B)reorganization.
C)liquidation.
D)repurchase program.
E)divestiture.

Accepted Answer

A reorganization is a financial restructuring of a failing firm designed to attempt to allow it to continue operating as a going concern. A merger involves two companies combining into one, a liquidation is the process of selling off a firm’s assets to settle its debts, a repurchase program is a process of a company buying back its own shares, and a divestiture is the process of a company selling off a part of its business.

Question 12

The complete termination of a firm as a going business concern is called a:
A)liquidation.
B)repurchase program.
C)merger.
D)divestiture.
E)reorganization.

Accepted Answer

Liquidation refers to the complete and orderly termination of a firm's operations and the sale of its assets to pay off its creditors and investors. This is usually done when a company is unable to pay its debts and is deemed insolvent. Therefore, the best choice to describe the complete termination of a firm as a going business concern is liquidation.

Question 13

Which one of the following statements concerning bankruptcy is correct?
A)An indirect cost of bankruptcy is the loss of key employees.
B)Bondholders have a greater incentive than stockholders to keep a firm from filing for bankruptcy.
C)Bankruptcy is sometimes used as a means to increase payroll costs.
D)The assets of a firm tend to increase in value when a firm is in financial distress.
E)The administrative costs incurred in a bankruptcy are considered indirect bankruptcy costs.

Accepted Answer

When a firm files for bankruptcy, key employees may leave the company due to uncertainty about job security or dissatisfaction with the current management. This leads to an indirect cost of bankruptcy for the company.

Answer: B
 Bondholders have a higher priority claim on the assets of the company than stockholders in the event of bankruptcy. Therefore, they have a greater incentive to keep the firm from filing for bankruptcy and avoid losing their investment.

Answer: None of the statements C, D, and E are correct.
 Statement C is incorrect because bankruptcy is used to reduce expenses, not increase them. Statement D is incorrect because in financial distress, the firm's assets may decrease in value due to a lack of demand or unfavorable market conditions. Statement E is incorrect because administrative costs incurred in a bankruptcy are considered direct bankruptcy costs.

Question 14

The explicit costs,such as the legal expenses,associated with corporate default are classified as _____ costs.
A)unlevered
B)direct bankruptcy
C)beta conversion
D)indirect bankruptcy
E)flotation

Accepted Answer

Direct bankruptcy costs are the expenses incurred by a company when it goes bankrupt, including legal and administrative costs associated with the bankruptcy process. These are explicit costs that directly result from the default.

Question 15

The optimal capital structure:
A)of a firm will vary over time as taxes and market conditions change.
B)is unaffected by changes in the financial markets.
C)will be the same for all firms in the same industry.
D)places more emphasis on the operations of a firm rather than the financing of a firm.
E)will remain constant over time unless the firm makes an acquisition.

Accepted Answer

The optimal capital structure of a firm may vary over time due to changes in tax policies, economic conditions, and market conditions. Therefore, A is the correct choice. B is wrong because changes in the financial markets affect the optimal capital structure of a firm. C is wrong because each firm in an industry has unique characteristics that influence their capital structure. D is wrong because the capital structure is an integral part of the financing of a firm. E is wrong because the optimal capital structure of a firm may change even if it does not make an acquisition.

Question 16

The value of a firm is maximized when the:
A)weighted average cost of capital is minimized.
B)levered cost of capital is maximized.
C)tax rate is zero.
D)cost of equity is maximized.
E)debt-equity ratio is minimized.

Accepted Answer

The value of a firm is maximized when the weighted average cost of capital (WACC) is minimized because WACC is the minimum return required by all of the firm's investors. Minimizing WACC means that the firm is able to raise funds at a lower cost, which ultimately leads to a higher value for the firm.

Question 17

The optimal capital structure of a firm _____ the marketed claims and _____ the nonmarketed claims against the cash flows of the firm.
A)minimizes; minimizes
B)maximizes; minimizes
C)minimizes; maximizes
D)maximizes; maximizes
E)equates; (leave blank)

Accepted Answer

The optimal capital structure maximizes the value of marketed claims (like debt and equity) while minimizing the costs or value of nonmarketed claims (like taxes, bankruptcy costs).

Question 18

The basic lesson of MM theory is that the value of a firm is dependent upon the:
A)capital structure of the firm.
B)total cash flows of the firm.
C)percentage of a firm to which the bondholders have a claim.
D)tax claim placed on the firm by the government.
E)size of the stockholders claims on the firm.

Accepted Answer

According to MM theory, the value of a firm is dependent upon the total cash flows of the firm. This is because the theory assumes that investors can borrow and lend money at the same rate and therefore, changes in the capital structure do not affect the value of the firm. The percentage of a firm to which the bondholders have a claim, tax claim placed on the firm by the government, and size of the stockholders' claims on the firm are all related to the capital structure and do not directly affect the total cash flows of the firm.

Question 19

A firm that has a negative net worth is said to be:
A)experiencing a business failure.
B)in legal bankruptcy.
C)experiencing technical insolvency.
D)experiencing accounting insolvency.
E)in Chapter 11 bankruptcy reorganization.

Accepted Answer

Accounting insolvency occurs when a firm has a negative net worth, which means its liabilities are greater than its assets based on accounting principles. This doesn't necessarily mean the firm is failing or in legal bankruptcy, but it does suggest that it may have difficulty meeting its financial obligations in the long run. Technical insolvency refers to a situation where a firm is unable to pay its debts as they come due, regardless of its accounting net worth.

Question 20

The explicit and implicit costs associated with corporate default are referred to as the _____ costs of a firm.
A)flotation
B)default beta
C)direct bankruptcy
D)indirect bankruptcy
E)financial distress

Accepted Answer

The explicit and implicit costs associated with corporate default are referred to as the financial distress costs of a firm.

Quiz 15: Capital Structure: Limits to the Use of Debt

Which one of the following statements is correct concerning a Chapter 7 bankruptcy?

The costs of avoiding a bankruptcy filing by a financially distressed firm are classified as _____ costs.

The optimal capital structure will tend to include more debt for firms with:

The legal proceeding for liquidating or reorganizing a firm operating in default is called a:

In general,the capital structures used by U.S.firms:

A firm is technically insolvent when:

Indirect bankruptcy costs:

Corporations in the U.S.tend to:

The optimal capital structure has been achieved when the:

An attempt to financially restructure a failing firm so that it can continue operating as a going concern is called a:

The complete termination of a firm as a going business concern is called a:

Which one of the following statements concerning bankruptcy is correct?

The explicit costs,such as the legal expenses,associated with corporate default are classified as _____ costs.

The optimal capital structure:

The value of a firm is maximized when the:

The optimal capital structure of a firm _ the marketed claims and _ the nonmarketed claims against the cash flows of the firm.

The basic lesson of MM theory is that the value of a firm is dependent upon the:

A firm that has a negative net worth is said to be:

The explicit and implicit costs associated with corporate default are referred to as the _____ costs of a firm.