Corporate Finance, 12e (Ross)
1) Which one of these lowers cash flows?
A) Decreased use of leverage
B) Decreased costs
C) Increased sales due to an improved economy
D) The associated costs of bankruptcy
E) A decrease in the interest rate charged on debt
2) The explicit costs, such as the legal expenses, associated with corporate default are classified
as:
A) debt flotation costs.
B) beta conversion costs.
C) direct costs of financial distress.
D) indirect bankruptcy costs.
E) unlevered costs of capital.
3) What is the estimated direct cost of financial distress as a percentage of the market value of a
firm as estimated by White, Altman, and Weiss?
A) 3 percent
B) 5 percent
C) 8 percent
D) 1 percent
E) 10 percent
4) Which one of the following is a direct, rather than an indirect, cost of financial distress?
A) Key employee leaving for another job due to concerns over job security given the company’s
financial status
B) Loss of a key supplier due to late payments to that supplier
C) Fees paid to financial advisors related to bankruptcy matters
D) Loss of customers due to concerns the company will close
E) Money spent to send a mailing to customers dispelling any and all financial distress concerns
about the company
5) Conflicts of interest between stockholders and bondholders are known as:
A) trustee costs.
B) financial distress costs.
C) dealer costs.
D) agency costs.
E) underwriting costs.
6) One of the indirect costs of bankruptcy is the effect that a potential bankruptcy has on the
firm’s decisions. The general result is that:
A) the firm will rank all projects and select the project which results in the highest expected firm
value.
B) bondholders expropriate value from stockholders by selecting high-risk projects.
C) stockholders expropriate value from bondholders by selecting high-risk projects.
D) the firm will always select the lowest-risk project available.
E) the firm will select only all-equity financed projects.
7) One of the indirect costs of bankruptcy is the incentive toward underinvestment.
Underinvestment generally would result in:
A) the firm selecting all projects with positive NPVs.
B) the firm turning down positive NPV projects that would clearly be accepted if the firm were
all-equity financed.
C) bondholders contributing the full amount of any new investment, but both stockholders and
bondholders sharing in the benefits of those investments.
D) shareholders making decisions based on the best interests of the bondholders.
E) the firm accepting more projects than it would if the probability of bankruptcy was ignored.
8) Which one of these best exemplifies “milking the property”?
A) A firm paying a premium to acquire a competitor
B) A firm demanding a premium to be acquired without a proxy fight
C) A firm with high financial distress paying additional dividends
D) An all-equity firm repurchasing shares
E) A firm with high financial distress using expected dividends to repay debt
9) Shareholders sometimes pursue selfish strategies when financial distress is present. These
actions generally result in:
A) no action by debtholders since these are shareholder concerns.
B) agency costs to bondholders.
C) investments with risks similar to those of the current firm.
D) undertaking scale-enhancing projects.
E) lower agency costs, as shareholders have more control over the firm’s assets.
10) Bondholders tend to offset the effects of selfish strategies implemented by shareholders by:
A) restructuring their loans to provide additional time to the firm to make repayment.
B) subordinating their bankruptcy position to the shareholders.
C) agreeing to reduce the outstanding principal balances on their loans.
D) agreeing to reduce the interest rate on existing loans.
E) increasing the interest rate on monies loaned to the firm.
11) Covenants restricting additional borrowings primarily protect the:
A) shareholders’ residual interests in the firm.
B) debtholders from the added risk of dilution of their claims.
C) debtholders from changes in market interest rates.
D) managers by avoiding agency costs.
E) shareholders from agency costs.
12) If a firm issues debt and includes protective covenants in the indenture then the firm’s debt
will probably be issued at ________ similar debt without the covenants.
A) a variable interest rate rather than the fixed rate paid on
B) a lower interest rate than
C) a significantly higher interest rate than
D) an interest rate equal to that of
E) a slightly higher interest rate than
13) Which one of these is most related to a positive covenant?
A) Limiting the amount of the firm’s dividends
B) Avoiding a merger while a debt remains unpaid
C) Furnishing financial statements to the firm’s lenders
D) Not issuing any additional long-term debt
E) Not selling any major assets without lender approval
14) Suppose a potential bondholder requires an indenture agreement to include a limit on
dividend distributions by the bond’s issuer and also a restriction on the sale of the issuer’s assets.
In this case, the bondholder is most likely concerned about:
A) shareholder claims being diluted.
B) shareholders claiming all of the residual profits of the firm.
C) increasing interest rates.
D) shareholders transferring firm assets to themselves.
E) shareholders earning a higher return on their investment in the firm than the bondholders earn
on their debt.
15) Which one of these represents a difference between business entities in Japan and in the
United States?
A) Lenders in Japan frequently also take ownership positions in firms to which they lend.
B) Debt-equity ratios tend to be higher in the U.S. than they are in Japan.
C) There tends to be greater agency issues between stockholders and bondholders in Japan as
compared to the U.S.
D) Bondholders in Japan are prohibited from also being shareholders in the same firm.
E) The debt-equity ratios for firms in Japan and in the U.S. tend to be relatively equal.
16) Which one of these parties holds a marketable claim on a firm’s assets?
A) Customers
B) Employees
C) Bondholders
D) Internal Revenue Service
E) State tax authorities
17) The value of a firm is maximized when the:
A) cost of equity is maximized.
B) tax rate is zero.
C) levered cost of capital is maximized.
D) weighted average cost of capital is minimized.
E) debt-equity ratio is minimized.
18) The optimal capital structure has been achieved when the:
A) debt-equity ratio is equal to 1.
B) weight of equity is equal to the weight of debt.
C) cost of equity is maximized given a pretax cost of debt.
D) debt-equity ratio is such that the cost of debt exceeds the cost of equity.
E) present value of the financial distress costs equals the present value of the tax shield on debt.
19) In a world with taxes and financial distress, when a firm is operating with the optimal capital
structure the:
A) debt-equity ratio will be minimized.
B) weighted average cost of capital will be maximized.
C) firm will be all-equity financed.
D) required return on assets will be at its maximum point.
E) overall benefits of debt have all been realized.
20) The optimal capital structure of a firm ________ the marketable claims and ________ the
nonmarketable claims against the cash flows of the firm.
A) minimizes; minimizes
B) minimizes; maximizes
C) maximizes; minimizes
D) maximizes; maximizes
E) equates; (leave blank)
21) The MM theory with taxes implies that firms should issue maximum debt. In practice, this
does not occur because:
A) debt is more risky than equity.
B) bankruptcy is a disadvantage to debt.
C) the weighted average cost of capital is inversely related to the debt-equity ratio.
D) the weighted average cost of capital is directly related to the debt-equity ratio.
E) U.S. regulations require the debt-equity ratio of publicly-traded firms to be in the range of .3
to .7.
22) Assuming the interest on the debt is fully tax deductible, when firms issue more debt, the
present value of the tax shield on debt ________ while the present value of the financial distress
costs ________.
A) decreases; decreases
B) increases; increases
C) decreases; remains constant
D) decreases; increases
E) increases; remains constant
23) The Supply Depot is considering issuing $1 million in bonds but their financial staff has
advised that if they do, the value of the firm will decrease. Given this advice, you know the staff
believes the firm:
A) currently is all-equity financed and adding debt will cause a decrease in firm value.
B) wants to issue too few bonds to obtain the most benefit from debt.
C) will suffer from a decrease in its WACC if the bonds are issued.
D) is at, or has exceeded, its optimal debt-equity ratio.
E) will realize greater tax benefits by issuing equity securities.
24) Which one of the following statements is true?
A) A firm with low anticipated profits will likely take on a high level of debt.
B) A successful firm will probably be all-equity financed.
C) Rational firms raise debt levels when profits are expected to decline.
D) Rational investors are likely to infer a firm is more valuable when its debt level declines.
E) Investors will generally view an increase in debt as a positive sign for the firm’s future value.
25) A decrease in a firm’s level of debt tends to imply:
A) an increase in the firm’s market value.
B) an increase in future dividend payouts.
C) a decrease in the firm’s stock price.
D) a decrease in the firm’s position within its industry.
E) a decline in managerial efficiency.
26) Assume that for the next two weeks, the bondholders of Western Markets have the option of
exchanging their bonds for common shares of the firm’s stock. As a result of these exchanges,
you should expect the firm’s debt-equity ratio to:
A) decline and the stock’s price to also decline.
B) decline and the stock’s price to remain constant.
C) decline and the stock’s price to increase.
D) increase and the stock’s price to increase.
E) increase and the stock’s price to remain constant.
27) The free cash flow hypothesis states that:
A) firms with greater free cash flow will pay higher dividends thereby reducing the risk of
financial distress.
B) firms with greater free cash flow should issue new equity to help minimize the wasting of
resources by managers.
C) issuing debt requires payments to creditors thereby reducing the ability of managers to waste
resources.
D) firms should reduce their debt levels as their level of free cash flow rises.
E) firms with higher levels of free cash flow should reward their managers with bonuses.
28) Issuing debt instead of new equity in a closely held firm is most apt to cause:
A) the owner-manager to work less hard and shirk duties.
B) the owner-manager to consume more perquisites because the cost is passed to the debtholders.
C) both more shirking and perquisite consumption since the government provides a tax shield on
debt.
D) agency costs to fall as owner-managers do not need to worry about other shareholders.
E) the owner-manager to reduce shirking and perquisite consumption.
29) The pecking order states that firms should:
A) use internal financing first.
B) always issue debt so the market won’t know when managers believe the stock is overvalued.
C) issue new equity first.
D) issue debt first.
E) always issue equity to avoid financial distress costs.
30) According to the pecking-order theory, a firm’s leverage ratio is determined by:
A) the value of the tax benefit of debt.
B) equating the tax benefit of debt to the financial distress costs of debt.
C) the firm’s financing needs.
D) the market rate of interest.
E) the profitability of the firm.
31) Which one of the following is not implied by the pecking order theory?
A) Profitable firms tend to use less debt than unprofitable firms.
B) Companies like having financial slack.
C) Companies prefer to borrow up to the point where the financial distress costs offset the tax
benefit of debt.
D) There is no target debt-equity ratio for a firm.
E) Firms tend to accumulate cash in anticipation of future projects.
32) The introduction of personal taxes may reveal a disadvantage to the use of corporate debt if
the personal tax rate on:
A) the distribution of income to stockholders is less than the personal tax rate on interest income.
B) the distribution of income to stockholders is greater than the personal tax rate on interest
income.
C) the distribution of income to stockholders is equal to the personal tax rate on interest income.
D) interest income is zero.
E) dividends and interest are equal.
33) Ignore financial distress costs. When [(1 − TC) × (1 − TS) = (1 − TB)], then firms:
A) should be all-equity financed.
B) need to maintain a debt-equity ratio of .5.
C) tend to be indifferent between issuing debt or issuing equity.
D) discover that both dividends and interest payments are non-deductible business expenses.
E) can reduce their taxes by increasing their dividend payouts.
34) Of these five U.S. industries, which one tends to have the highest level of debt as a
percentage of the market value of debt plus equity?
A) Construction supplies
B) Semiconductor
C) Hotel/gaming
D) Online retail
E) Healthcare products
35) Studies have found that firms with large investments in tangible assets tend to have:
A) higher financial distress costs than firms with comparable investments in intangible assets.
B) zero debt.
C) higher target debt-equity ratios than firms that primarily invest in intangible assets.
D) the highest financial distress costs of any firm per dollar of debt.
E) the same capital structure as firms that specialize in intangible asset investments.