Multiple Choice - Part 7: Financial Distress, Bankruptcy, Agency Costs, Optimal Capital Structure

6.1 Which of the following statements is FALSE about default and bankruptcy?

A) Equity holders expect to receive dividends and the firm is legally obligated to pay them

B) A firm that fails to make required interest or principal payments on its debt is in default

C) In the extreme case debt holders take legal ownership of the firm’s assets through bankruptcy

D) After default debt holders gain certain rights to the firm’s assets

A) Equity holders expect to receive dividends and the firm is legally obligated to pay them

6.2 Which of the following statements is FALSE about direct vs indirect bankruptcy costs?

A) Although indirect costs are hard to measure they are typically much smaller than direct bankruptcy costs

B) Bankruptcy protection can be used by management to delay liquidation of a firm that should be shut down

C) Because many aspects of bankruptcy are independent of firm size costs are higher in percentage terms for smaller firms

D) Besides legal and administrative costs many other indirect costs are associated with financial distress

A) Although indirect costs are hard to measure they are typically much smaller than direct bankruptcy costs

6.3 Which of the following statements is FALSE about distress and customers suppliers or assets?

A) Fire sale losses are greatest for firms whose assets lack competitive liquid markets

B) Firms in financial distress often have trouble collecting receivables

C) Suppliers may refuse to provide inventory if they fear they will not be paid

D) Loss of customers is likely to be large for producers of raw materials such as sugar or aluminum because the value of these goods once delivered depends on the seller’s continued success

D) Loss of customers is likely to be large for producers of raw materials such as sugar or aluminum because the value of these goods once delivered depends on the seller’s continued success

6.4 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

A) Legal fees

6.5 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

C) Costs of appraisers

6.6 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

A) Costs to creditors

6.7 Which of the following statements is FALSE about who bears distress costs?

A) Debt holders recognize that in default they may not get full asset value and so pay less for debt initially

B) Financial distress costs are an important departure from MM’s perfect capital markets assumption

C) Financial distress costs reduce cash flows available to investors

D) When securities are fairly priced the original shareholders of a firm pay the future value of bankruptcy and financial distress costs

D) When securities are fairly priced the original shareholders of a firm pay the future value of bankruptcy and financial distress costs

6.8 Which of the following statements is FALSE about valuing financial distress costs?

A) Calculating the precise present value of distress costs is relatively straightforward

B) Two key qualitative factors are the probability of distress and the magnitude of costs in distress

C) Technology firms can have high distress costs due to loss of customers key personnel and few tangible assets

D) The magnitude of distress costs depends on their sources and varies by industry

A) Calculating the precise present value of distress costs is relatively straightforward

6.9 Which of the following statements is FALSE about the trade off between tax shields and distress costs?

A) The presence of distress costs can explain why firms choose debt levels that are too high to fully exploit the interest tax shield

B) With higher distress costs it is optimal to choose lower leverage

C) Differences in distress costs and cash flow volatility help explain leverage differences across industries

D) At the optimal debt level where firm value is maximized the marginal tax benefit of extra debt equals the marginal expected cost of distress

A) The presence of distress costs can explain why firms choose debt levels that are too high to fully exploit the interest tax shield

6.10 A type of agency problem where shareholders gain from decisions that sufficiently increase firm risk even if NPV is negative is called what?

A) Asset substitution

B) Debt overhang

C) Underinvestment

D) Cashing out

A) Asset substitution

6.11 A type of agency problem where shareholders gain by refusing to finance new positive NPV projects is called what?

A) Asset substitution

B) Debt overhang

C) Excessive risk taking

D) Distress costs

B) Debt overhang

6.12 Which of the following statements is FALSE about agency costs with leverage?

A) When a firm faces financial distress creditors can gain by making sufficiently risky negative NPV investments

B) With leverage conflicts of interest can arise if investment decisions affect equity and debt values differently

C) Managers may sometimes take actions that benefit shareholders but harm creditors and lower total firm value

D) Agency costs arise when there are conflicts of interest between stakeholders

A) When a firm faces financial distress creditors can gain by making sufficiently risky negative NPV investments

6.13 The cost of which problem is highest for firms with profitable future growth opportunities that require large investments?

A) Asset substitution

B) Debt overhang

C) Debt covenants

D) Debt maturity

B) Debt overhang

6.14 The cost of which problem is highest for firms that can easily increase the risk of their investments?

A) Asset substitution

B) Debt overhang

C) Debt covenants

D) Debt maturity

A) Asset substitution

6.15 Which of the following statements is FALSE about managerial agency problems and leverage?

A) One disadvantage of using leverage is that it does not allow original owners to maintain their equity stake

B) Separation of ownership and control can lead to management entrenchment

C) Managers have personal interests that may differ from both equity and debt holders

D) Reduced effort and excessive perk consumption are forms of agency cost

A) One disadvantage of using leverage is that it does not allow original owners to maintain their equity stake

What does the trade off theory of capital structure say?

A) Firms set leverage to maximise EPS

B) Firms choose leverage by trading off the tax benefits of debt against expected costs of financial distress and agency

C) Firms should always minimize leverage

D) Firms choose leverage randomly

B) Firms choose leverage by trading off the tax benefits of debt against expected costs of financial distress and agency

At the optimal capital structure in the trade off theory which condition roughly holds?

A) Total debt equals total equity

B) Marginal tax benefit of additional debt equals marginal expected cost of financial distress

C) Debt equals zero

D) Firm value equals book value

B) Marginal tax benefit of additional debt equals marginal expected cost of financial distress

According to the free cash flow hypothesis how can debt create value?

A) By increasing distress costs

B) By forcing managers to pay out excess cash instead of wasting it on negative NPV projects and perks

C) By making taxes higher

D) By increasing EPS mechanically

B) By forcing managers to pay out excess cash instead of wasting it on negative NPV projects and perks

What is the main purpose of debt covenants?

A) To increase tax shields from interest

B) To protect managers from shareholders

C) To restrict actions that could harm debtholders and shift value to shareholders

D) To guarantee dividends

C) To restrict actions that could harm debtholders and shift value to shareholders

Which firm is most likely to suffer large underinvestment (debt overhang) problems?

A) A mature utility with stable cash flows and little growth

B) A highly levered growth firm with many positive NPV projects that require new financing

C) A firm with no debt and no growth opportunities

D) A bank with government guarantees

B) A highly levered growth firm with many positive NPV projects that require new financing

Which firm is most exposed to the asset substitution problem?

A) A firm financed entirely with equity

B) A firm with little flexibility in project choice

C) A firm whose managers can easily shift from low risk to high risk projects after debt is in place

D) A firm whose debt is fully collateralized by cash

C) A firm whose managers can easily shift from low risk to high risk projects after debt is in place

According to the pecking order theory what is the preferred sequence of financing?

A) Debt first then equity then internal cash

B) Equity then debt then internal cash

C) Internal cash then debt then equity

D) Equity only

C) Internal cash then debt then equity

Why do growth firms with intangible assets often have lower target leverage than mature asset heavy firms?

A) Because banks refuse to lend to them at any rate

B) Because they face lower tax rates

C) Because their distress and under investment costs are high and they have few tangible assets as collateral

D) Because they do not care about capital structure

C) Because their distress and underinvestment costs are high and they have few tangible assets as collateral

How can a leverage increase be interpreted as a signal in some models?

A) As a sign that managers expect low future cash flows

B) As a sign that managers expect high future cash flows and are willing to commit to fixed payments

C) As a sign that taxes will fall

D) As a sign that equity is overvalued

B) As a sign that managers expect high future cash flows and are willing to commit to fixed payments

When a firm with existing risky debt issues new risky debt of equal seniority what often happens?

A) Value is transferred from old debtholders to new debtholders

B) Value is transferred from new debtholders to old debtholders

C) Value is transferred from shareholders to debtholders

D) No value transfer occurs

B) Value is transferred from new debtholders to old debtholders