Exam
Name___________________________________
MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.
1)
Which of the following statements is false?
1)
A)
Firms have an incentive to increase leverage to exploit the tax benefits of debt. But with too
much debt, they are more likely to risk default and incur financial distress costs.
B)
According to the tradeoff theory, the total value of a levered firm equals the value of the firm
without leverage plus the present value of the tax savings from debt, less the present value of
financial distress costs.
C)
The tradeoff theory weighs the costs of debt that result from shielding cash flows from taxes
against the benefits from the effects of financial distress associated with leverage.
D)
Leverage has costs as well as benefits.
Use the information for the question(s) below.
Monsters Incorporated (MI) in ready to launch a new product. Depending upon the success of this product, MI will have a
value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are
unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of
capital equal to the risk–free rate, which is currently 5%. Assume that the capital markets are perfect.
2)
Assume that in the event of default, 20% of the value of MI’s assets will be lost in bankruptcy costs
and suppose that MI has zero–coupon debt with a $125 million face value due next year. The
present value of MI’s financial distress costs is closest to:
2)
A)
$6.3 million
B)
$19.0 million
C)
$20.0 million
D)
$6.6 million
3)
Which of the following statements is false?
3)
A)
The tradeoff theory explains how firms should choose their capital structures to maximize
value to current shareholders.
B)
Proponents of the management entrenchment theory of capital structure believe that
managers choose a capital structure to avoid the discipline of debt and maintain their own job
security.
C)
Firms with high R&D costs and future growth opportunities typically maintain high debt
levels.
D)
With tangible assets, the financial distress costs of leverage are likely to be low, as the assets
can be liquidated for close to their full value.
4)
Which of the following statements is false?
4)
A)
Agency costs represent another cost of increasing the firm’s leverage that will affect the firm’s
optimal capital structure choice.
B)
An under–investment problem occurs when shareholders choose to not invest in a
positive–NPV project.
C)
The agency costs of debt can arise only if there is no chance the firm will default and impose
losses on its debt holders.
D)
When a firm faces financial distress, it may choose not to finance new, positive–NPV projects.
5)
Which of the following statements is false?
5)
A)
If the debt level is too large firm value is reduced due to the loss of tax benefits (when interest
exceeds EBIT), financial distress costs, and the agency costs of leverage.
B)
As the debt level increases, the firm benefits from the interest tax shield (which has present
value *D).
C)
As the debt level increases, the firm faces worse incentives for management, which increase
wasteful investment and perks.
D)
The optimal level of debt D*, balances the costs and benefits of leverage.
6)
Which of the following statements is false?
6)
A)
An over–investment problem occurs when shareholders have an incentive to invest in risky
positive–NPV projects.
B)
When a firm faces financial distress, shareholders have an incentive not to invest and to
withdraw money from the firm if possible.
C)
A negative–NPV project destroys value for the firm overall.
D)
Because top managers often hold shares in the firm and are hired and retained with the
approval of the board of directors, which itself is elected by shareholders, managers will
generally make decisions that increase the value of the firm’s equity.
Use the information for the question(s) below.
Luther Industries has no debt and expects to generate free cash flows of $48 million each year. Luther believes that if it
permanently increases its level of debt to $100 million, the risk of financial distress may cause it to lose some customers and
receive less favorable terms from its suppliers. As a result, Luther’s expected free cash flows with debt will be only $44 million
per year. Suppose Luther’s tax rate is 40%, the risk–free rate is 6%, the expected return of the market is 14%, and the beta of
Luther’s free cash flows is 1.25 (with or without leverage).
7)
The value of Luther without leverage is closest to:
7)
A)
$340 million
B)
$300 million
C)
$205 million
D)
$315 million
Use the information for the question(s) below.
Monsters Incorporated (MI) in ready to launch a new product. Depending upon the success of this product, MI will have a
value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are
unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of
capital equal to the risk–free rate, which is currently 5%. Assume that the capital markets are perfect.
8)
Assume that in the event of default, 20% of the value of MI’s assets will be lost in bankruptcy costs
and suppose that MI has zero–coupon debt with a $125 million face value due next year. The total
value of MI with leverage is closest to:
8)
A)
$140 million
B)
$125 million
C)
$100 million
D)
$134 million
9)
Suppose that MI has zero–coupon debt with a $125 million face value due next year. The expected
return of MI’s debt is closest to:
9)
A)
7.8%
B)
5.0%
C)
25.0%
D)
12.5%
Use the information for the question(s) below.
Kinston Enterprises has no debt and a debt obligation of $47 million that is due now. The market value of Kinston’s assets is
$102 million, and the firm has no other liabilities. Assume that capital markets are perfect and that Kinston has 5 million
shares outstanding.
10)
The number of new shares that Kinston must issue to raise the capital needed to pay its debt
obligation is closest to:
10)
A)
5.0 million
B)
4.3 million
C)
4.7 million
D)
4.0 million
Use the information for the question(s) below.
Big Blue Banana (BBB) is a clothing retailer with a current share price of $10.00 and with 25 million shares outstanding.
Suppose that Big Blue Banana announces plans to lower its corporate taxes by borrowing $100 million and using the
proceeds to repurchase shares.
11)
Suppose that BBB pays corporate taxes of 35% and that shareholders expects the change in debt to
be permanent. Assuming that capital markets are perfect except for the existence of corporate
taxes, the share price for BBB after this announcement is closest to:
11)
A)
$10.85
B)
$10.00
C)
$8.60
D)
$11.40
Use the information for the question(s) below.
Monsters Incorporated (MI) in ready to launch a new product. Depending upon the success of this product, MI will have a
value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are
unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of
capital equal to the risk–free rate, which is currently 5%. Assume that the capital markets are perfect.
12)
Assume that in the event of default, 20% of the value of MI’s assets will be lost in bankruptcy costs
and suppose that MI has zero–coupon debt with a $125 million face value due next year. The
initial value of MI’s equity is closest to:
12)
A)
$15 million
B)
$24 million
C)
$30 million
D)
$29 million
Use the information for the question(s) below.
You own your own firm and you need to raise $50 million to fund an expansion. Following the expansion, your firm will be
worth $75 million in its unlevered form. You want to go ahead with the expansion, but you are concerned that you may not
be able to maintain ownership of over 50% of your firm’s equity. In other words, you are concerned that if you use equity to
finance the expansion, you may loose control of your firm.
13)
Assume that capital markets are perfect, you issue $30 million in new debt, and you issue $20
million in new equity. You ownership stake in the firm following these new issues of debt and
equity is closest to:
13)
A)
55%
B)
58%
C)
33%
D)
50%
14)
Which of the following firms is likely to maintain low levels of debt?
14)
A)
An electric utility
B)
A mature restaurant chain
C)
An internet firm
D)
A tobacco company
Use the information for the question(s) below.
You own your own firm and you need to raise $50 million to fund an expansion. Following the expansion, your firm will be
worth $75 million in its unlevered form. You want to go ahead with the expansion, but you are concerned that you may not
be able to maintain ownership of over 50% of your firm’s equity. In other words, you are concerned that if you use equity to
finance the expansion, you may loose control of your firm.
15)
Assume that capital markets are perfect except for the existence of corporate taxes. Your firm pays
40% of earnings in taxes and you decide to issue $25 million in new debt and $25 million in new
equity. You ownership stake in the firm following these new issues of debt and equity is closest to:
15)
A)
55%
B)
33%
C)
50%
D)
58%
Use the information for the question(s) below.
JR Industries has a $20 million loan due at the end of the year and under its current business strategy its assets will have a
market value of only $15 million when the loan comes due. JR is considering a new much riskier business strategy. While
this new riskier strategy can be implemented using JR’s existing assets without any additional investment, the new strategy
has only a 40% probability of succeeding. If the new strategy is a success, the market value of JR‘s assets will be $30, but if
the strategy fails the assets will be worth only $5 million.
16)
What is the overall expected payoff under JR’s new riskier business strategy?
16)
A)
$11 million
B)
$4 million
C)
$20 million
D)
$15 million
17)
Which of the following statements is false?
17)
A)
The tradeoff theory states that firms should increase their leverage until it reaches the level D*
for which VL is maximized.
B)
If there were no costs of financial distress, the value of the firm would continue to increase
with increasing debt until the interest on the debt exceeds the firm’s earnings before interest
and taxes and the tax shield is exhausted.
C)
Firms with steady, reliable cash flows, such as utility companies, are able to use high levels of
debt and still have a very low probability of default.
D)
The costs of financial distress reduce the value of the levered firm, VL. The amount of the
reduction decreases with the probability of default, which in turn increases with the level of
the debt D.
Use the information for the question(s) below.
Wildcat Drilling is an oil and gas exploration company that currently operating two active oil fields with a market value of
$200 million dollars each. Unfortunately, Wildcat Drilling has $500 million in debt coming due at the end of the year. A
large oil company has offered Wildcat drilling a highly speculative, but potentially very valuable, oil and gas lease in
exchange for one of their active oil fields. If Wildcat accepts the trade, there is a 10% chance that Wildcat will discover a
major new oil field that would be worth $1.2 billion, a 15% that Wildcat will discover a productive oil field that would be
worth $600 million, and a 75% chance that Wildcat will not discover oil at all.
18)
What is the expected payoff to equity holders with the speculative oil lease deal?
18)
A)
$160 million
B)
$85 million
C)
$10 million
D)
$275 million
B
19)
Which of the following statements is false?
19)
A)
When agency costs are significant, short–term debt may be the most attractive form of
external financing.
B)
The most important insight regarding capital structure goes back to Modigliani and Miller:
With perfect capital markets, a firm’s security choice alters the risk of the firm’s equity, but it
does not change its value or the amount it can raise from outside investors.
C)
Of all the different possible imperfections that drive capital structure, the most clear–cut, and
possibly the most significant, is taxes.
D)
Too much debt can motivate managers and equity holders to take excessive risks or
over–invest in a firm.
D
D
20)
Which of the following is not a direct cost of bankruptcy?
20)
A)
Costs of accounting experts
B)
Legal Costs and Fees
C)
Investment Banking Costs
D)
Costs to Creditors
Use the information for the question(s) below.
You own your own firm and you need to raise $50 million to fund an expansion. Following the expansion, your firm will be
worth $75 million in its unlevered form. You want to go ahead with the expansion, but you are concerned that you may not
be able to maintain ownership of over 50% of your firm’s equity. In other words, you are concerned that if you use equity to
finance the expansion, you may loose control of your firm.
21)
Assume that capital markets are perfect, you issue $25 million in new debt, and you issue $25
million in new equity. You ownership stake in the firm following these new issues of debt and
equity is closest to:
21)
A)
55%
B)
33%
C)
50%
D)
58%
Use the information for the question(s) below.
Luther Industries has no debt and expects to generate free cash flows of $48 million each year. Luther believes that if it
permanently increases its level of debt to $100 million, the risk of financial distress may cause it to lose some customers and
receive less favorable terms from its suppliers. As a result, Luther’s expected free cash flows with debt will be only $44 million
per year. Suppose Luther’s tax rate is 40%, the risk–free rate is 6%, the expected return of the market is 14%, and the beta of
Luther’s free cash flows is 1.25 (with or without leverage).
22)
The value of Luther with leverage is closest to:
22)
A)
$340 million
B)
$315 million
C)
$205 million
D)
$300 million
23)
Which of the following statements is false?
23)
A)
With perfect capital markets, the risk of bankruptcy is not a disadvantage of debt–bankruptcy
simply shifts the ownership of the firm from equity holders to debt holders without changing
the total value available to all investors.
B)
Bankruptcy is a long and complicated process that imposes both direct and indirect costs on
the firm and its investors that the assumption of perfect capital markets ignores.
C)
Bankruptcy is rarely simple and straightforward–equity holders don’t just “hand the keys” to
debt holders the moment the firm defaults on a debt payment.
D)
When a firm fails to make a required payment to debt holders, it is in bankruptcy.
Use the information for the question(s) below.
Monsters Incorporated (MI) in ready to launch a new product. Depending upon the success of this product, MI will have a
value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are
unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of
capital equal to the risk–free rate, which is currently 5%. Assume that the capital markets are perfect.
24)
Assume that in the event of default, 20% of the value of MI’s assets will be lost in bankruptcy costs
and suppose that MI has zero–coupon debt with a $125 million face value due next year. The
initial value of MI’s debt is closest to:
24)
A)
$110 million
B)
$125 million
C)
$105 million
D)
$111 million
25)
The initial value of MI’s equity without leverage is closest to:
25)
A)
$147 million
B)
$140 million
C)
$133 million
D)
$150 million
Use the information for the question(s) below.
If it is managed efficiently, Luther industries will have assets with market value of $100 million, $300, million, or $500
million next year, with each outcome being equally likely. Managers may, however, engage in wasteful empire building
which will reduce the firm’s market value by $20 million in all cases. Managers may also increase the risk of the firm,
changing the probability of each outcome to 50%, 20%, and 30% respectively.
26)
If it is managed efficiently, then the expected market value of Luther’s assets is closest to:
26)
A)
$240
B)
$280 million
C)
$260
D)
$300 million
Use the information for the question(s) below.
Electronic Gaming Incorporated (EGI) is a firm with no debt and its 20 million shares are currently trading for $16 per share.
Based on the prospects for EGI’s new hand held video game, management feels the true value of the firm is $20 per share.
Management believes that the share price will reflect this higher value after the video game is released next fall. EGI has
already announced plans to raise $100 million from investors to build a new factory.
27)
Assume that EGI decides to raise the $100 million through the issuance of new shares prior to the
release of the new video game. The number of new shares that EGI will issue is closest to:
27)
A)
6.25 million
B)
10 million
C)
5.0 million
D)
1.6 million
Use the information for the question(s) below.
Big Blue Banana (BBB) is a clothing retailer with a current share price of $10.00 and with 25 million shares outstanding.
Suppose that Big Blue Banana announces plans to lower its corporate taxes by borrowing $100 million and using the
proceeds to repurchase shares.
28)
Assuming perfect capital markets, the share price for BBB after this announcement is closest to:
28)
A)
$10.00
B)
$8.60
C)
$11.40
D)
$10.85
Use the information for the question(s) below.
If it is managed efficiently, Luther industries will have assets with market value of $100 million, $300, million, or $500
million next year, with each outcome being equally likely. Managers may, however, engage in wasteful empire building
which will reduce the firm’s market value by $20 million in all cases. Managers may also increase the risk of the firm,
changing the probability of each outcome to 50%, 20%, and 30% respectively.
29)
If its managers increase the risk of the firm, then the expected market value of Luther’s assets is
closest to:
29)
A)
$240
B)
$280 million
C)
$300 million
D)
$260
30)
If its managers engage in empire building, then the expected market value of Luther’s assets is
closest to:
30)
A)
$300 million
B)
$260
C)
$280 million
D)
$240
Use the information for the question(s) below.
JR Industries has a $20 million loan due at the end of the year and under its current business strategy its assets will have a
market value of only $15 million when the loan comes due. JR is considering a new much riskier business strategy. While
this new riskier strategy can be implemented using JR’s existing assets without any additional investment, the new strategy
has only a 40% probability of succeeding. If the new strategy is a success, the market value of JR‘s assets will be $30, but if
the strategy fails the assets will be worth only $5 million.
31)
What is the expected payoff to equity holders under JR’s new riskier business strategy?
31)
A)
$20 million
B)
$11 million
C)
$4 million
D)
$15 million
Use the information for the question(s) below.
Monsters Incorporated (MI) in ready to launch a new product. Depending upon the success of this product, MI will have a
value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are
unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of
capital equal to the risk–free rate, which is currently 5%. Assume that the capital markets are perfect.
32)
Suppose that MI has zero–coupon debt with a $125 million face value due next year. The initial
value of MI’s debt is closest to:
32)
A)
$125 million
B)
$100 million
C)
$116 million
D)
$111 million
33)
Which of the following statements is false?
33)
A)
In Chapter 13 liquidation, a trustee is appointed to oversee the liquidation of the firm’s assets
through an auction. The proceeds from the liquidation are used to pay the firm’s creditors,
and the firm ceases to exist.
B)
In the case of Chapter 11 reorganization, creditors must often wait several years for a
reorganization plan to be approved and to receive payment.
C)
The creditors must vote to accept the Chapter 11 reorganization plan, and the bankruptcy
court must approve it. If an acceptable plan is not put forth, the court may ultimately force a
Chapter 7 liquidation of the firm.
D)
When a corporation becomes financially distressed, outside professionals, such as legal and
accounting experts, consultants, appraisers, auctioneers, and others with experience selling
distressed assets, are generally hired.
34)
Which of the following statements is false?
34)
A)
A study of Chapter 7 liquidations of small businesses found that the average direct costs of
bankruptcy were 12% of the value of the firm’s assets.
B)
The direct costs of bankruptcy are likely to be higher for firms with more complicated
business operations and for firms with larger numbers of creditors, because it may be more
difficult to reach agreement among many creditors regarding the final disposition of the firm
’s assets.
C)
Studies typically report that the average direct costs of bankruptcy are approximately 3% to
4% of the pre–bankruptcy market value of total assets.
D)
In a prepackaged bankruptcy (or “prepack”) a firm will first develop a reorganization plan
with the agreement of its main creditors, and then file Chapter 7 to implement the plan and
pressure any creditors who attempt to hold out for better terms.
35)
Which of the following statements is false?
35)
A)
Agency costs are smallest for long–term debt.
B)
Creditors often place restrictions on the actions that the firm can take. Such restrictions are
referred to as debt covenants.
C)
Covenants may limit the firm‘s ability to pay large dividends or the types of investments that
the firm can make.
D)
Covenants are often designed to prevent management from exploiting debt holders, so they
may help to reduce agency costs.
36)
Which of the following statements is false?
36)
A)
When a firm has leverage, a conflict of interest exists if investment decisions have different
consequences for the value of equity and the value of debt.
B)
When a firm faces financial distress, creditors can gain by making sufficiently risky
investments, even if they have negative NPV.
C)
In some circumstances, managers may take actions that benefit shareholders but harm the
firm’s creditors and lower the total value of the firm.
D)
Agency costs are costs that arise when there are conflicts of interest between stakeholders.
Use the information for the question(s) below.
JR Industries has a $20 million loan due at the end of the year and under its current business strategy its assets will have a
market value of only $15 million when the loan comes due. JR is considering a new much riskier business strategy. While
this new riskier strategy can be implemented using JR’s existing assets without any additional investment, the new strategy
has only a 40% probability of succeeding. If the new strategy is a success, the market value of JR‘s assets will be $30, but if
the strategy fails the assets will be worth only $5 million.
37)
What is the expected payoff to debt holders under JR‘s new riskier business strategy?
37)
A)
$20 million
B)
$15 million
C)
$4 million
D)
$11 million
Use the information for the question(s) below.
Electronic Gaming Incorporated (EGI) is a firm with no debt and its 20 million shares are currently trading for $16 per share.
Based on the prospects for EGI’s new hand held video game, management feels the true value of the firm is $20 per share.
Management believes that the share price will reflect this higher value after the video game is released next fall. EGI has
already announced plans to raise $100 million from investors to build a new factory.
38)
Assume that EGI decides to wait until after the release of the new video game before they raise the
$100 million through the issuance of new shares. The number of new shares that EGI will issue is
closest to:
38)
A)
6.25 million
B)
10 million
C)
5.0 million
D)
1.6 million
39)
Which of the following statements is false?
39)
A)
A firm that fails to make the required interest or principal payments on the debt is in default.
B)
In the extreme case, the debt holders take legal ownership of the firm’s assets through a
process called bankruptcy.
C)
After a firm defaults, debt holders are given certain rights to the assets of the firm.
D)
Equity holders expect to receive dividends and the firm is legally obligated to pay them.
D
40)
Which of the following statements is false?
40)
A)
At the point D*, where VL is maximized, the tax savings that result from increasing leverage
are just offset by the increased probability of incurring the costs of financial distress.
B)
The presence of financial distress costs can explain why firms choose debt levels that are too
high to fully exploit the interest tax shield.
C)
Differences in the magnitude of financial distress costs and the volatility of cash flows can
explain the differences in the use of leverage across industries.
D)
With higher costs of financial distress, it is optimal for the firm to choose lower leverage.
B
C
41)
Which of the following statements is false?
41)
A)
An important consequence of leverage is the risk of bankruptcy.
B)
Modigliani and Miller’s results continue to hold in a perfect market even when debt is risky
and the firm may default.
C)
Whether default occurs depends on the cash flows, not on the relative values of the firm’s
assets and liabilities.
D)
Economic distress is a significant decline in the value of a firm’s assets, whether or not it
experiences financial distress due to leverage.
Use the information for the question(s) below.
Wildcat Drilling is an oil and gas exploration company that currently operating two active oil fields with a market value of
$200 million dollars each. Unfortunately, Wildcat Drilling has $500 million in debt coming due at the end of the year. A
large oil company has offered Wildcat drilling a highly speculative, but potentially very valuable, oil and gas lease in
exchange for one of their active oil fields. If Wildcat accepts the trade, there is a 10% chance that Wildcat will discover a
major new oil field that would be worth $1.2 billion, a 15% that Wildcat will discover a productive oil field that would be
worth $600 million, and a 75% chance that Wildcat will not discover oil at all.
42)
What is the expected payoff to debt holders with the speculative oil lease deal?
42)
A)
$275 million
B)
$85 million
C)
$10 million
D)
$160 million
Use the information for the question(s) below.
Monsters Incorporated (MI) in ready to launch a new product. Depending upon the success of this product, MI will have a
value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are
unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of
capital equal to the risk–free rate, which is currently 5%. Assume that the capital markets are perfect.
43)
Assume that in the event of default, 20% of the value of MI’s assets will be lost in bankruptcy costs.
Suppose that at the start of the year, MI has no debt outstanding, but has 5.6 million shares of stock
outstanding. If MI does not issue debt, its share price is closest to:
43)
A)
$23.75
B)
$5.15
C)
$25.00
D)
$23.90
Use the information for the question(s) below.
You own your own firm and you need to raise $50 million to fund an expansion. Following the expansion, your firm will be
worth $75 million in its unlevered form. You want to go ahead with the expansion, but you are concerned that you may not
be able to maintain ownership of over 50% of your firm’s equity. In other words, you are concerned that if you use equity to
finance the expansion, you may loose control of your firm.
44)
Assume that capital markets are perfect except for the existence of corporate taxes and that your
firm pays 40% of earnings in taxes. If you want to maintain ownership of at least a 50%, then the
minimum amount of debt that you must issue to fund the expansion is closest to:
44)
A)
$16 million
B)
$20 million
C)
$18 million
D)
$19 million