Ch 11

Question 1

Sovereign Debt

Answer 1

Issued by the national government. In the US, sovereign debt is issued as bonds called “Treasury securities”

Question 2

Treasury Bills

Answer 2

These are zero-coupon bonds with maturities shorter than 1 year.

Question 3

Treasury Notes

Answer 3

These are semiannual coupon bonds with maturities ranging from 1 to 10 years.

Question 4

Treasury Bonds

Answer 4

These are semiannual coupon bonds with maturities longer than 10 years.

Question 5

Treasury Inflation-Protected Securities (TIPS)

Answer 5

These are semiannual coupon bonds where the principal is adjusted for inflation. Because the coupon rate is fixed, the coupon payment is also adjusted for inflation.

Question 6

Perfect Capital Markets 3 Assumptions

Answer 6

Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.
No taxes, transaction costs, or issuance costs.
The financing and investment decisions are independent of each other.

Question 7

Revenue Bonds

Answer 7

Revenue bonds are backed by the revenues that the projects will earn as a result of the debt issued.

Question 8

General Obligation Bonds

Answer 8

These bonds are backed by the full faith and credit of a local government. If local governments strengthen the commitment further by tying the promise to a particular revenue source, this commitment is over and above the usual commitment, and the bonds are called double-barreled.

Question 9

Interest Tax Shield

Answer 9

The use of debt results in tax savings for the firm, which adds to the value of the firm.
Interest tax shield=PV(Interest payments)
from permanent debt it equals the corporate tax rate times the debt.

Question 10

Default

Answer 10

A firm that fails to make its required payments to debt holders is said to default on its debt

Question 11

Bankruptcy

Answer 11

After a firm defaults, the debt holders have claims to the firm’s assets through a legal process called bankruptcy

Question 12

Perfect Capital Markets 3 Assumptions

Answer 12

Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.

No taxes, transaction costs, or issuance costs.
The financing and investment decisions are independent of each other.

Question 13

MM Propositions 1 Perfect Capital Markets

Answer 13

The total value of a firm is equal to the market value of the total cash flows generated by its asset.

The value of a firm is unaffected by its choice of capital structure.

Changing a firm’s capital structure merely changes how the value of its assets is divided between debt and equity, but no the firms’s total value.
V(L) =V(U)

Question 14

MM Proposition 2 Perfect Capital Markets

Answer 14

The CoC of levered equity increases with the firm’s debt-to-equity.

Because we have no taxes in a perfect capital market, the firm’s WACC and the unlevered CoC are equal.

Question 15

Interest Tax Shield

Answer 15

The use of debt results in tax savings for the firm, which adds to the value of the firm.

Interest tax shield=PV(Interest payments)

from permanent debt it equals the corporate tax rate times the debt.

Question 16

Managerial Entrenchment

Answer 16

Because managers face little threat of being replaced, managers can run the firm to suit their interests.

Question 17

Reason Leverage can provide incentives for managers to run a firm more efficiently and effectively (3)

Answer 17

Increased ownership concentration
Reduced wasteful investment
Reduced managerial entrenchment and increased commitment

Question 18

Free Cash Flow Hypothesis

Answer 18

Wasteful spending is more likely to happen when firms have high levels of cash flow in excess of what is needed.

Question 19

Asymmetric Information

Answer 19

When managers have more information about a firm than investors

Question 20

Who bears the Financial Distress Costs?

Answer 20

Debt holders reorganize that when the firm defaults, they will not be able to obtain the full value of the assets. As a result they will pay less (or demand higher yields) for the debt initially.

It is the equity holders who most directly bears the financial distress costs.

Question 21

Adverse Selection

Answer 21

A seller with private information is likely to sell you worse-than-average goods

Question 22

Credibility Principal

Answer 22

Claim’s on one’s self -interest are credible only if they are supported by actions that would be too costly to take if the claims were untrue.

Question 23

Reason Leverage can provide incentives for managers to run a firm more efficiently and effectively (3)

Answer 23

Increased ownership concentration

Reduced wasteful investment

Reduced managerial entrenchment and increased commitment

Question 24

Managers issuing debt viewed from investors

Answer 24

Issuing more debt it typically viewed as a positive signal as the company is taking on commitment to make timely interest and principal payments

Question 25

Adverse Selection Implications for Equity Issuance

Answer 25

The stock price declines on the announcement of an equity issue

The stock price tends to rise prior to the announcement of an equity issue

Firms tend to issue equity when information asymmetries are minimized, such as immediately after earnings announcement

Question 26

Pecking Order Hypothesis

Answer 26

Managers prefer to make financing choices that send positive rather than negative signals to outside investors

1. Internal generated equity(i.e retained earnings)
2. Debt
3. External Equity (i.e newly issued shares)

Question 27

Cash Flow Perspective

Answer 27

Associating cash inflows with positive signs and cash outflows with negative signs

Question 28

Cost Flow Perspective

Answer 28

Associating cash inflows with negative signs and cash outflows with positive signs

Question 29

When to use Cash Flow Perspective

Answer 29

1. Whenever a problem deals with cashflow-related items such as net cash flows or profits.
2. To synthetically create an asset. This is because it is easier to identify the cash flows needed to replicate the desired position when using the cash flow perspective.
3. To exploit arbitrage using the two-step approach of moving everything to the greater than side of the inequality, as presented above.