CF Chapter 16

Question 1

Does the risk of bankruptcy follow as a disadvantage?

Answer 1

No, as a debt bankruptcy means a shift from equity holder to debt holders

Question 2

What is the U.S bankruptcy code?

Answer 2

The process of organizing that the seizing of assets does not destroy value

Question 3

What is liquidation?

Answer 3

The firms assets are sold through a auction and this is to pay a firms creditors

Question 4

What is reorganization?

Answer 4

All pending collections are suspended and the firms management get a opportunity to propose a reorganization plan

Question 5

What are direct costs of bankruptcy?

Answer 5

The direct costs reduce the value of the assets that the firms investors will receive

Question 6

What is a workout? (Bankruptcy)

Answer 6

When a firm is succesful at reorganization outside of bankruptcy

Question 7

What is a prepackaged bankruptcy?

Answer 7

A firm will first develop a reorganization plan with agreement of creditors and then file for chapter 11

Question 8

What are the types of indirect costs of financial distress?

Answer 8

1. Loss ofcustomers
2. Loss of suppliers
3. Loss of employees
4. Loss of receivables
5. Fire sale of assets
6. Inefficient liquidation
7. Costs to creditors

Question 9

Debt holders will reduce the value of a firm in case of financial distress costs, what is the formula ultimately of the value of a levered firm?

Answer 9

VL = VU + PV (interest tax shield) - PV (financial distress costsWhat are t

Question 10

What are the three key factors in determining the present value of financial distress costs?

Answer 10

1. The probability of financial distress
2. The magnitude of the costs if the firm is in distress
3. The appropriate discount rate for the distress costs

Question 11

What are agency costs?

Answer 11

The costs that arise when there is a conflict of interest between stakeholders

Question 12

What is the idea of excessive risk taking in financial distress?

Answer 12

Well when a firm faces financial distress. the shareholder can gain from decisions that increa the risk of the firm sufficiently, even if they have a negative NPV

Question 13

What is revered to as the asset substitution problem?

Answer 13

That leverage gives shareholders an incentive to replaye low-risk assets with riskier ones

Question 14

What is the idea of debt overhang / Under-investment problem?

Answer 14

When shareholders prefer not to invest in positive-NPV projects in financial distress

Question 15

What is cashing out?

Answer 15

If a firm faces financial distress, shareholders may have an incentive to withdraw cash from the firm

Question 16

What is the leverage hatchet effect?

Answer 16

Once existing debt is in place, shareholders have an incentive to increase leverage even if it decreases the value of the firm and shareholders will not have an incentive to decrease leverage by buying back debt, even if it will increase the value of the firm

Question 17

What happens with the agency costs of short-term debt?

Answer 17

IT becomes smaller due to less opportunities to profit at the expense of debt holders

Question 18

What are debt covenants?

Answer 18

Restrictions placed on action that a firm can take and this reduces agency costs

Question 19

What is management entrenchment?

Answer 19

With facing little threat of being fires, managers are free to run the firm in their own best interest

Question 20

What is empire building?

Answer 20

When a manager is willing to engage in negative-npv investments as managers prefer to lead large firms

Question 21

What is overconfidence in agency costs?

Answer 21

When managers act in shareholders interest, but make mistakes due to believe

Question 22

What does leverage and agressive strategies have to do?

Answer 22

A highly leveraged firm may become a fierce competitor to protect its markets as it cannot risk bankruptcy