5) What are direct costs of inancial distress?
AACSB Objective: Analytic Skills
Author: SS
Question Status: Previous Edition
6) What are indirect costs of inancial distress?
AACSB Objective: Analytic Skills
Author: SS
Question Status: Previous Edition
16.5 Optimal Capital Structure: The Tradeof Theory
1) The presence of inancial distress costs can explain why irms choose debt levels that are
too low to exploit the interest tax shield.
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
2) Diferences in the magnitude of inancial distress costs and volatility of cash lows across
industries do not impact the choice of leverage.
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
31
3) The tradeof theory of optimal capital structure weighs the beneits of debt against the
costs of ________.
A) inancial distress
B) interest payments
C) dividend reinvestment
D) input factors
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
4) The Tradeof Theory suggests that ________.
A) a irm should choose a debt level where the tax savings from increasing leverage are just
ofset by the increased probability of incurring the costs of inancial distress
B) with higher costs of inancial distress, it is optimal for a irm to choose higher leverage
C) diferences in the magnitude of inancial distress costs and the volatility of cash lows
cannot explain the diferences in the use of leverage across industries
D) there is no rational explanation for why irms choose debt levels that are too low to fully
exploit the debt tax shield
AACSB Objective: Analytic Skills
Author: JP
Question Status: Previous Edition
5) One of the factors that determine the present value (PV) of inancial distress costs is
________.
A) costs of unpaid interest arrears
B) loss of dividend payments
C) probability of inancial distress
D) employee compensation
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
32
6) Firms in industries such as real estate tend to have ________ distress costs because of a
large proportion of tangible assets.
A) high
B) low
C) unexpected
D) varying
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
7) The probability of inancial distress depends on the ________.
A) likelihood that a irm will be unable to meet its debt commitments
B) chance that a irm’s raw material costs will increase
C) likelihood of dividend payments
D) likelihood of asset growth
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
8) As the level of debt increases the tax beneits of debt increase until ________.
A) interest costs exceed dividend payments
B) tax shield beneit exceeds distress costs
C) raw material costs exceed dividend payments
D) employee costs exceed interest expense
AACSB Objective: Relective Thinking Skills
Author: KB
Question Status: Previous Edition
9) What are the issues in determining the present value (PV) of inancial distress?
AACSB Objective: Analytic Skills
Author: SS
Question Status: Previous Edition
33
10) What are the issues in determining the optimal leverage for a irm?
AACSB Objective: Analytic Skills
Author: SS
Question Status: Previous Edition
16.6 Additional Consequences of Leverage: Agency Costs and Information
1) The presence of leverage can inluence the behavior of the managers of a irm.
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
2) Equity-debt holder conlicts are more likely to arise if the risk of inancial distress is
high.
AACSB Objective: Relective Thinking Skills
Author: JP
Question Status: New
3) Agency costs arise when ________.
A) there are high labor costs
B) input costs are higher than interest costs
C) interest costs exceed dividend payments
D) conlicts of interest exist between stakeholders
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
34
4) Managerial entrenchment means that managers ________ and run the irm for their own
best interests.
A) may face little threat of being ired
B) are overseen by equity holders
C) are overseen by debt holders
D) are well compensated
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
5) When a irm’s investment decisions have diferent consequences for the value of equity
and the value of debt, managers may take actions ________.
A) to increase debt values
B) to decrease costs of distress
C) that beneit shareholders at the expense of debt holders
D) to reduce ixed costs
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
6) The presence of a large amount of debt can encourage shareholders to take excessive
risk because ________.
A) equity holders are risk seeking by nature
B) the costs of failure are borne largely by debt holders
C) debt holders are risk seeking
D) irm value increases with risk taking
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
35
7) To reduce agency costs, issuing debt instead of equity provides incentives for managers
to run a irm eiciently because ________.
A) debt increases the funds available to managers to run the irm
B) ownership of managers may remain more concentrated
C) managers may take actions that beneit shareholders but harm creditors and lower the
value of the irm
D) shareholders prefer to decline new projects to save cash, even if their NPVs are positive
AACSB Objective: Analytic Skills
Author: JP
Question Status: Revised
8) Under-investment problems refers to the problem that equity holders prefer not to invest
in positive-NPV projects in highly levered irms because ________.
A) future investments are contingent on debt inancing
B) projects are contingent on equity inancing
C) gains are evenly shared between all stakeholders
D) most of the gains from the investment accrue to debt holders
AACSB Objective: Relective Thinking Skills
Author: KB
Question Status: Previous Edition
9) The use of leverage as a way to signal ________ information to investors is known as the
signaling theory of debt.
A) good
B) bad
C) random
D) none of the above
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
36
10) Asymmetric information implies that ________ may have better information about a
irm’s cash lows than other stakeholders.
A) debt holders
B) suppliers
C) managers
D) creditors
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
11) Market timing means that managers may sell ________ when they believe the stock is
over-valued and rely on ________ when the stock is undervalued.
A) debt, shares
B) debt, preferred stock
C) new shares, debt
D) debt, debt
AACSB Objective: Relective Thinking Skills
Author: KB
Question Status: Previous Edition
12) The pecking order hypothesis states that managers will have a preference to fund
investment by using ________, followed by ________, and will issue ________ as a last resort.
A) debt, equity, retained earnings
B) retained earnings, equity, debt
C) retained earnings, debt, equity
D) debt, retained earnings, equity
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
37
16.7 Capital Structure: Putting It All Together
1) Managers should make use of the interest tax shield if a irm has ________.
A) consistent taxable income
B) volatility in taxable income
C) consistent dividend payments
D) low tax rates
AACSB Objective: Relective Thinking Skills
Author: KB
Question Status: Previous Edition
2) Managers should consider ________ for external inancing when agency costs are
signiicant.
A) long-term debt
B) retained earnings
C) internal equity
D) short-term debt
AACSB Objective: Relective Thinking Skills
Author: KB
Question Status: Previous Edition
3) Managers should not change the capital structure unless it departs signiicantly from the
optimal level because such a change would ________.
A) reduce dividends
B) incur transactions costs
C) increase ixed costs
D) change incentives of stakeholders
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
38
4) The optimal capital structure depends on ________ such as taxes, distress costs and
agency costs.
A) capital market factors
B) market imperfections
C) irm speciic risks
D) systematic risks
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
39