Deck 16: Financial Distress,managerial Incentives,and Information

Question 1

The number of new shares that Kinston must issue to raise the capital needed to pay its debt obligation is closest to:

A)4.3 million
B)4.7 million
C)5.0 million
D)4.0 million

Answer 1

4.3 million

Question 2

Which of the following statements is FALSE?

A)According to the provisions of the 1978 Bankruptcy Reform Act,U.S.firms can file for two forms of bankruptcy protection: Chapter 11 or Chapter 13.
B)The Chapter 11 reorganization plan specifies the treatment of each creditor of the firm.In addition to cash payment,creditors may receive new debt or equity securities of the firm.The value of cash and securities is generally less than the amount each creditor is owed,but more than the creditors would receive if the firm were shut down immediately and liquidated.
C)In the more common form of bankruptcy for large corporations,Chapter 11 reorganization,all pending collection attempts are automatically suspended,and the firm's existing management is given the opportunity to propose a reorganization plan.
D)While developing a Chapter 11 reorganization plan,management continues to operate the business.

Answer 2

According to the provisions of the 1978 Bankruptcy Reform Act,U.S.firms can file for two forms of bankruptcy protection: Chapter 11 or Chapter 13.

Question 3

Assuming your cost of capital is 6 percent,the present value of your expected wage if you accept Rearden Metal's offer is closest to:

A)$133,000
B)$138,000
C)$140,000
D)$144,000

Answer 3

$138,000

Question 4

Taggart Transcontinental has a value of $500 million if it continues to operate,but has outstanding debt of $600 million.If Taggart declares bankruptcy,bankruptcy costs will equal $50 million,and the remaining $450 million will go to creditors.Instead of declaring bankruptcy,Taggart proposes to exchange the firm's debt for a fraction of its equity in a workout.The minimum fraction of the firm's equity that Taggart would need to offer to its creditors for the workout to be successful is closest to:

A)50%
B)75%
C)83%
D)90%

Question 5

If you take the job with Wyatt Oil,then,in the event of bankruptcy,the least amount that Wyatt Oil would pay you next year is closest to:

A)$45,000
B)$50,000
C)$54,000
D)$75,000

Question 6

Kinston's current share price is closest to:

A)$20.40
B)$9.40
C)$11.00
D)$10.00

Question 7

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:

A)25.0%
B)12.5%
C)5.0%
D)7.8%

Question 8

Assuming your cost of capital is 6 percent,based on the present value of your expected wage you should:

A)accept Rearden's offer since the PV of your expected wage would be approximately $6000 higher.
B)accept Rearden's offer since the PV of your expected wage would be approximately $8000 lower.
C)accept Rearden's offer since the PV of your expected wage would be approximately $8000 higher.
D)accept Wyatt's offer since the PV of your expected wage would be approximately $6000 higher.

Question 9

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:

A)$30 million
B)$15 million
C)$29 million
D)$24 million

Question 10

The initial value of MI's equity without leverage is closest to:

A)$133 million
B)$147 million
C)$140 million
D)$150 million

Question 11

Suppose that MI has zero-coupon debt with a $140 million face value due next year.Calculate the value of levered equity,the value of debt,and the total value of MI with leverage.

Question 12

Which of the following statements is FALSE?

A)When a firm fails to make a required payment to debt holders,it is in bankruptcy.
B)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.
C)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.
D)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.

Question 13

Which of the following statements is FALSE?

A)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.
B)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.
C)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.
D)In the case of Chapter 11 reorganization,creditors must often wait several years for a reorganization plan to be approved and to receive payment.

Question 14

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:

A)$125 million
B)$111 million
C)$100 million
D)$116 million

Question 15

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:

A)$133 million
B)$140 million
C)$147 million
D)$125 million

Question 16

Assuming your cost of capital is 6 percent,the present value of your expected wage if you accept Wyatt Oil's offer is closest to:

A)$138,000
B)$140,000
C)$144,000
D)$150,000

Question 17

Which of the following statements is FALSE?

A)An important consequence of leverage is the risk of bankruptcy.
B)Whether default occurs depends on the cash flows,not on the relative values of the firm's assets and liabilities.
C)Economic distress is a significant decline in the value of a firm's assets,whether or not it experiences financial distress due to leverage.
D)Modigliani and Miller's results continue to hold in a perfect market even when debt is risky and the firm may default.

Question 18

Suppose that MI has zero-coupon debt with a $125 million face value due next year.The yield to maturity of MI's debt is closest to:

A)12.5%
B)7.8%
C)25.0%
D)5.0%

Question 19

Which of the following statements is FALSE?

A)The U.S.bankruptcy code was created to organize this process so that creditors are treated fairly and the value of the assets is not needlessly destroyed.
B)Because the assets of the firm might be more valuable if kept together,creditors seizing assets in a piecemeal fashion might destroy much of the remaining value of the firm.
C)Debt holders can then take legal action against the firm to collect payment by seizing the firm's assets.
D)Because most firms have multiple creditors,coordination makes it difficult to guarantee that each creditor will be treated fairly.

Question 20

Which of the following statements is FALSE?

A)Equity holders expect to receive dividends and the firm is legally obligated to pay them.
B)A firm that fails to make the required interest or principal payments on the debt is in default.
C)In the extreme case,the debt holders take legal ownership of the firm's assets through a process called bankruptcy.
D)After a firm defaults,debt holders are given certain rights to the assets of the firm.

Question 21

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

Question 22

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:

A)$20.0 million
B)$6.6 million
C)$6.3 million
D)$19.0 million

Question 23

Which of the following statements is FALSE?

A)Although indirect costs of bankruptcy are difficult to measure accurately,they are typically much smaller than the direct costs of bankruptcy.
B)Bankruptcy protection can be used by management to delay the liquidation of a firm that should be shut down.
C)Because many aspects of the bankruptcy process are independent of the size of the firm,the costs are typically higher,in percentage terms,for smaller firms.
D)Aside from the direct legal and administrative costs of bankruptcy,many other indirect costs are associated with financial distress (whether or not the firm has formally filed for bankruptcy).

Question 24

List five general categories of indirect costs associated with bankruptcy.

Question 25

Use the following information to answer the question(s)below.
d'Anconia Copper is considering issuing one year debt,and has come up with the following estimates of the value of the interest tax shield and the probability of distress for different levels of debt:
If in the event of distress,the present value of distress costs is equal to $10 million,then the optimal level of debt for d'Anconia Copper is:

A)$25 million
B)$50 million
C)$60 million
D)$70 million

Question 26

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:

A)$5.15
B)$23.75
C)$23.90
D)$25.00

Question 27

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:

A)$110 million
B)$105 million
C)$125 million
D)$111 million

Question 28

Which of the following statements is FALSE?

A)The costs of selling assets below their value are greatest for firms with assets that lack competitive,liquid markets.
B)Firms in financial distress tend to have difficulty collecting money that is owed to them.
C)Suppliers may be unwilling to provide a firm with inventory if they fear they will not be paid.
D)The loss of customers is likely to be large for producers of raw materials (such as sugar or aluminum),as the value of these goods,once delivered,depends on the seller's continued success.

Question 29

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:

A)$140 million
B)$100 million
C)$125 million
D)$134 million

Question 30

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

Question 31

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

Question 32

Assuming that in the event of default,20% of the value of MI's assets will be lost in bankruptcy costs,the initial value of MI's equity without leverage is closest to:

A)$150 million
B)$147 million
C)$140 million
D)$133 million

Question 33

Because debtor-in-possession (DIP)financing is senior to all existing creditors:

A)it allows a firm that has filed for bankruptcy renewed access to financing to keep operating.
B)it is an important cost for firms that rely heavily on trade credit.
C)it is likely to be small for producers of raw materials,as the value of those goods,once delivered,does not depend on the seller's continued success.
D)it allows debtors to assume they may have an opportunity to avoid their obligations to a firm.

Question 34

Which of the following statements is FALSE?

A)Debt holders are not foolish-they recognize that when the firm defaults,they will not be able to get the full value of the assets.As a result,they will pay less for the debt initially.
B)The costs of financial distress represent an important departure from Modigliani and Miller's assumption of perfect capital markets.
C)Levered firms risk incurring financial distress costs that reduce the cash flows available to investors.
D)When securities are fairly priced,the original shareholders of a firm pay the future value of the costs associated with bankruptcy and financial distress.

Question 35

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 yield to maturity of MI's debt is closest to:

A)13.75%
B)5.00%
C)19.25%
D)12.50%

Question 36

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 $140 million face value due next year.Calculate the value of levered equity,the value of debt,and the total value of MI with leverage.

Question 37

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 issues debt of $125 million due next year and uses the proceeds to repurchase shares,the share price following the announcement of the repurchase will be closest to:

A)$23.90
B)$23.75
C)$25.00
D)$5.15

Question 38

Which of the following statements is FALSE?

A)Whether paid by the firm or its creditors,the indirect costs of bankruptcy increase the value of the assets that the firm's investors will ultimately receive.
B)In addition to the money spent by the firm,the creditors may incur costs during the bankruptcy process.
C)The bankruptcy code is designed to provide an orderly process for settling a firm's debts.
D)To ensure that their rights and interests are respected,and to assist in valuing their claims in a proposed reorganization,creditors may seek separate legal representation and professional advice.

Question 39

Which of the following statements is FALSE?

A)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.
B)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.
C)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.
D)Studies typically report that the average direct costs of bankruptcy are approximately 3% to 4% of the pre-bankruptcy market value of total assets.

Question 40

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:

A)$30 million
B)$29 million
C)$15 million
D)$24 million

Question 41

Which of the following statements is FALSE?

A)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.
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)The costs of financial distress reduce the value of the levered firm,V^L.The amount of the reduction decreases with the probability of default,which in turn increases with the level of the debt D.
D)The tradeoff theory states that firms should increase their leverage until it reaches the level D* for which V^L is maximized.

Question 42

Use the following information to answer the question(s)below.
Nielson Motors has a debt-equity ratio of 1.8,an equity beta of 1.6,and a debt beta of 0.20.It is currently evaluating the following projects,none of which would change Nielson's volatility.
(All amounts are in $millions.)
Which of the following projects should Nielson Motors accept?

A)1 only
B)1,2,and 3 only
C)1 and 4 only
D)2,3,and 5 only

Question 43

Which of the following statements is FALSE?

A)Calculating the precise present value of financial distress costs is a relatively straightforward process.
B)Two key qualitative factors determine the present value of financial distress costs: (1)the probability of financial distress and (2)the magnitude of the costs after a firm is in distress.
C)Technology firms are likely to incur high costs when they are in financial distress,due to the potential for loss of customers and key personnel,as well as a lack of tangible assets that can be easily liquidated.
D)The magnitude of the financial distress costs will depend on the relative importance of the sources of these costs and is likely to vary by industry.

Question 44

The total debt overhang associated with accepting project 1,is closest to:

A)$0 million
B)$12.5 million
C)$14.4 million
D)$22.5 million

Question 45

Use the following information to answer the question(s)below.
Nielson Motors has a debt-equity ratio of 1.8,an equity beta of 1.6,and a debt beta of 0.20.It is currently evaluating the following projects,none of which would change Nielson's volatility.
(All amounts are in $millions.)
Nielson Motors should accept those projects with profitability ratios greater than:

A)0.15
B)0.175
C)0.20
D)0.225

Question 46

Use the following information to answer the question(s)below.
d'Anconia Copper is considering issuing one year debt,and has come up with the following estimates of the value of the interest tax shield and the probability of distress for different levels of debt:
If in the event of distress,the present value of distress costs is equal to $5 million,then the optimal level of debt for d'Anconia Copper is:

A)$25 million
B)$50 million
C)$60 million
D)$70 million

Question 47

In order for Nielson Motor's to be willing to invest,project 5 must have an NPV greater than:

A)$10.0 million
B)$12.5 million
C)$18.0 million
D)$22.5 million

Question 48

The value of Luther with leverage is closest to:

A)$315 million
B)$340 million
C)$205 million
D)$300 million

Question 49

The total debt overhang associated with accepting project 4,is closest to:

A)$0 million
B)$13.5 million
C)$15.0 million
D)$38.6 million

Question 50

Which of the following statements is FALSE?

A)Real estate firms are likely to have low costs of financial distress,as much of their value derives from assets that can be sold relatively easily.
B)For low levels of debt,the risk of default remains low and the main effect of an increase in leverage is an increase in the interest tax shield,which has present value τ*D,where τ* is the effective tax advantage of debt.
C)Firms whose value and cash flows are very volatile (for example,semiconductor firms)must have much higher levels of debt to avoid a significant risk of default.
D)The probability of financial distress depends on the likelihood that a firm will be unable to meet its debt commitments and therefore default.

Question 51

Suppose that BBB pays corporate taxes of 35% and that shareholders expects the change in debt to be permanent.Assume that capital markets are perfect except for the existence of corporate taxes and financial distress costs.If the price of BBB's stock rises to $10.85 per share following the announcement,then the present value of BBB's financial distress costs is closest to:

A)$21.25 million
B)$35.00 million
C)$11.40 million
D)$13.75 million

Question 52

The value of Luther without leverage is closest to:

A)$315 million
B)$300 million
C)$205 million
D)$340 million

Question 53

Which of the following industries is likely to have the lowest costs of financial distress?

A)Airlines
B)Computer software
C)Biotechnology
D)Electric utilities

Question 54

Which of the following industries likely to have the highest costs of financial distress?

A)Grocery store
B)Semiconductors
C)Real estate
D)Utilities

Question 55

Which of the following statements is FALSE?

A)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.
B)Leverage has costs as well as benefits.
C)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.
D)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.

Question 56

Use the following information to answer the question(s)below.
d'Anconia Copper is considering issuing one year debt,and has come up with the following estimates of the value of the interest tax shield and the probability of distress for different levels of debt:
If in the event of distress,the present value of distress costs is equal to $25 million,then the optimal level of debt for d'Anconia Copper is:

A)$50 million
B)$60 million
C)$70 million
D)$80 million

Question 57

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:

A)$10.00
B)$10.85
C)$8.60
D)$11.40

Question 58

Suppose that BBB pays corporate taxes of 40% and that shareholders expects the change in debt to be permanent.Assume that capital markets are perfect except for the existence of corporate taxes and financial distress costs.If the price of BBB's stock rises to $10.80 per share following the announcement,then the present value of BBB's financial distress costs is closest to:

Question 59

Assuming perfect capital markets,the share price for BBB after this announcement is closest to:

A)$11.40
B)$10.85
C)$10.00
D)$8.60

Question 60

Which of the following statements is FALSE?

A)The presence of financial distress costs can explain why firms choose debt levels that are too high to fully exploit the interest tax shield.
B)With higher costs of financial distress,it is optimal for the firm to choose lower leverage.
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)At the point D*,where V^L is maximized,the tax savings that result from increasing leverage are just offset by the increased probability of incurring the costs of financial distress.

Question 61

What is the expected payoff to equity holders with the speculative oil lease deal?

A)$10 million
B)$160 million
C)$275 million
D)$85 million

Question 62

If Nielson Motors invests in only those projects which are beneficial to the stockholders,then the total debt overhang associated with accepting these project(s)is closest to:

A)$22.5 million
B)$36.0 million
C)$38.0 million
D)$57.5 million

Question 63

Which of the following statements is FALSE?

A)The agency costs of debt can arise only if there is no chance the firm will default and impose losses on its debt holders.
B)Agency costs represent another cost of increasing the firm's leverage that will affect the firm's optimal capital structure choice.
C)An under-investment problem occurs when shareholders choose to not invest in a positive-NPV project.
D)When a firm faces financial distress,it may choose not to finance new,positive-NPV projects.

Question 64

In an agency problem known as debt overhang,if the company has risky debt outstanding,equity holders will choose to invest only if:

A)the NPV of the project exceeds a cutoff equal to the relative riskiness of the firm's debt times its debt-equity ratio.
B)the profitability index of the project exceeds a cutoff equal to the relative riskiness of the firm's debt times its debt-equity ratio.
C)the NPV of the project is negative.
D)the debt holders will lose all their money.

Question 65

Which of the following statements is FALSE?

A)When a firm faces financial distress,shareholders have an incentive not to invest and to withdraw money from the firm if possible.
B)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.
C)An over-investment problem occurs when shareholders have an incentive to invest in risky positive-NPV projects.
D)A negative-NPV project destroys value for the firm overall.

Question 66

The cost of ________ 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

Question 67

What is the expected payoff to debt holders with the speculative oil lease deal?

A)$10 million
B)$275 million
C)$85 million
D)$160 million

Question 68

The cost of ________ is highest for firms that are likely to have profitable future growth opportunities requiring large investments.

A)asset substitution
B)debt overhang
C)debt covenants
D)debt maturity

Question 69

A type of agency problem that results in shareholders gaining from decisions that increase the risk of the firm sufficiently,even if they have negative NPV is:

A)asset substitution.
B)debt overhang.
C)underinvestment.
D)cashing out.

Question 70

A type of agency problem that results in shareholders gaining by choosing not to finance new,positive-NPV projects is:

A)asset substitution.
B)debt overhang.
C)excessive risk-taking.
D)distress costs.

Question 71

Which of the following statements is FALSE?

A)When a firm faces financial distress,creditors can gain by making sufficiently risky investments,even if they have negative NPV.
B)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.
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.

Question 72

In an agency problem known as asset substitution,the agency cost is paid by:

A)the debt holders,since if the risky project is not successful debt holders will lose all their money.
B)the debt holders,since if the risky project is successful debt holders will receive less money.
C)the equity holders,since the strategy has a negative expected payoff.
D)the equity holders,since they will lose all their money whether or not the project is successful.

Question 73

Which of the following statements is FALSE?

A)Creditors often place restrictions on the actions that the firm can take.Such restrictions are referred to as debt covenants.
B)Covenants are often designed to prevent management from exploiting debt holders,so they may help to reduce agency costs.
C)Agency costs are smallest for long-term debt.
D)Covenants may limit the firm's ability to pay large dividends or the types of investments that the firm can make.

Question 74

Which of the following agency problems represents a form of moral hazard?

A)asset substitution
B)debt overhang
C)cashing out
D)All of the above are examples of moral hazard.

Question 75

In order for Nielson Motor's to be willing to invest,project 3 must have an NPV greater than:

A)$12.5 million
B)$15.0 million
C)$22.5 million
D)$27.0 million

Question 76

The term moral hazard refers to:

A)the chance the firm will default and impose losses on its debtholders.
B)the under-investment problem.
C)the over-investment problem.
D)the idea that individuals will change their behavior if they are not fully exposed to its consequences.

Question 77

What is the expected payoff to equity holders under JR's new riskier business strategy?

A)$15 million
B)$11 million
C)$20 million
D)$4 million

Question 78

What is the expected payoff to debt holders under JR's new riskier business strategy?

A)$20 million
B)$4 million
C)$15 million
D)$11 million

Question 79

What is the overall expected payoff to Wildcat from the speculative oil lease deal?

A)$360 million
B)$275 million
C)$85 million
D)$160 million

Question 80

What is the overall expected payoff under JR's new riskier business strategy?

A)$4 million
B)$11 million
C)$20 million
D)$15 million