Ch. 18: How Much should a Corporation Borrow Flashcards
When taxes are introduced to the MM world, company debt and personal debt are no longer perfect substitutes - why?
Corporate debt can benefit from interest tax shields, whilst personal debt cannot. I.e., the firm is now able to offer investors something they cannot replicate by homemade leverage
Define bankruptcy costs
Bankruptcy costs reflect the disadvantage of excessive debt financing
Costs of using the legal mechanism allowing creditors to take over when a firm defaults (i.e., legal and administrative costs: fees to lawyers, accountants, and consultants).
All these are examples of ______ ______
Direct bankruptcy costs
The difficulties of managing a company while it is going through bankruptcy/ financial distress is referred to as _____
Indirect bankruptcy costs
_____ bankruptcy costs are often higher than _____ bankruptcy costs
Fill in: direct/ indirect
INDIRECT bankruptcy costs are often higher than DIRECT bankruptcy costs
Which of the following is an example of bankruptcy costs?
A) suppliers are reluctant to do business with the firm if the firm’s leverage is ill-managed
B) customers are reluctant to purchase from the firm if the firm’s leverage is ill-managed
C) employees are less willing to work for a firm if the firm’s leverage is ill-managed
D) fees to lawyers are higher for a firm if the firm’s leverage is ill-managed
D) fees to lawyers are higher for a firm if the firm’s leverage is ill-managed
All other options are cost of financial distress before/no bankruptcy
The optimal investment decision is impacted by the investment’s financing structure
True/ False
True
For example, on pp. 118: project 1 is better (lower risk and higher expected return) if fully equity financed. But given debt financing, project 2 is better since project 1 offers no outcome where payoff is positive
Firms/ managers will favor risky projects over safe ones when debt is high
True/ False
True: when debt is high, equity becomes option-like, since the firm is essentially gambling with debtholders’ money - creditors suffer the loss if the project goes wrong
When a company becomes overleveraged to a point where it can no longer make investments in growth opportunities; since no additional debt can be raised and since shareholders refuse to contribute equity to finance the project due to the firm being in financial distress - this situation is termed: ____
A) risk-shifting
B) asset substitution
C) underinvestment problem
C) underinvestment problem
When firms are in financial distress, two value-destroying games are played. Which?
A) Risk-shifting/ asset substitution
B) Empire building
C) Underinvestment problem
D) Agency problem
A) Risk-shifting/ asset substitution
C) Underinvestment problem
Wo pays the costs of playing the games (occurring from excessive borrowing) ex ante (before trouble)?
A) stockholders
B) bondholders
C) board
D) stakeholders
Ex-ante (before trouble):
A) stockholders
Wo pays the costs of playing the games (occurring from excessive borrowing) ex post (after trouble)?
A) stockholders
B) bondholders
C) board
D) stakeholders
Ex-post (after trouble): B) bondholders
Debt covenants refer to debt contracts specifying restrictions on management decisions, designed to prevent firms from playing games at the expense of creditors.
True/ False
True
Which of the following are examples of debt covenants?
A) Limitations on dividends
B) Restrictions on additional borrowing
C) Limitations of sale of assets
D) Restrictions on investment policy/ risk-shifting
E) Specification of accounting procedures
F) Limitations on M&A activities
G) All of the above
H) All except 1
G) All of the above
Creditors cannot fully eliminate the costs associates with lenders’ excessive borrowing. Why?
It is costly to make the contracts/ negotiate, and difficult to monitor and enforce the covenants/ contracts
Which of the following types of firms likely have the highest debt ratios?
A) Investment banks
B) Airplane manufacturers
C) Hotels
D) Consulting firms
B) Airplane manufacturers
C) Hotels
These firms have more a larger pool of tangible assets = higher collateral
Unprofitable firms ought to have higher debt ratios
True/ False
False:
Unprofitable firms ought to rely primarily n equity financing since it is risky/ expensive to raise debt due to the lack of profitability
Which of the following statements is/are FALSE about financial slack? (Choose all correct)
A) arise from cash, marketable securities, readily saleable real assets, and ready access to debt markets
B) financial slack is valuable since it allows the firm to use the top of the pecking order (internal financing) following the Pecking Order Theory
C) Financial slack entails that financing is quickly available for positive NPV projects
D) Financial slack can be disadvantageous since it decreases liquidity
E) Financial slack is most valuable for firms with high growth opportunities
False:
D) Financial slack can be disadvantageous since it decreases liquidity
According to Jensen’s FCF Theory, too much financial slack might be a drawback, because it might encourage managers to expand their perks and lead to empire building (overinvestment) with cash that should be paid back to stockholders.
True/ False
True
Recall: financial slack can be limited by debt:
Debt can discipline managers who are tempted to invest too much
Debt can provide pressure to force improvements in operating efficiency
