Ch. 18: How Much should a Corporation Borrow

Question 1

When taxes are introduced to the MM world, company debt and personal debt are no longer perfect substitutes - why?

Answer 1

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

Question 2

Define bankruptcy costs

Answer 2

Bankruptcy costs reflect the disadvantage of excessive debt financing

Question 3

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 ______ ______

Answer 3

Direct bankruptcy costs

Question 4

The difficulties of managing a company while it is going through bankruptcy/ financial distress is referred to as _____

Answer 4

Indirect bankruptcy costs

Question 5

_____ bankruptcy costs are often higher than _____ bankruptcy costs

Fill in: direct/ indirect

Answer 5

INDIRECT bankruptcy costs are often higher than DIRECT bankruptcy costs

Question 6

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

Answer 6

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

Question 7

The optimal investment decision is impacted by the investment’s financing structure

True/ False

Answer 7

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

Question 8

Firms/ managers will favor risky projects over safe ones when debt is high

True/ False

Answer 8

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

Question 9

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

Answer 9

C) underinvestment problem

Question 10

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

Answer 10

A) Risk-shifting/ asset substitution
C) Underinvestment problem

Question 11

Wo pays the costs of playing the games (occurring from excessive borrowing) ex ante (before trouble)?
A) stockholders
B) bondholders
C) board
D) stakeholders

Answer 11

Ex-ante (before trouble):
A) stockholders

Question 12

Wo pays the costs of playing the games (occurring from excessive borrowing) ex post (after trouble)?
A) stockholders
B) bondholders
C) board
D) stakeholders

Answer 12

Ex-post (after trouble): B) bondholders

Question 13

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

Answer 13

True

Question 14

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

Answer 14

G) All of the above

Question 15

Creditors cannot fully eliminate the costs associates with lenders’ excessive borrowing. Why?

Answer 15

It is costly to make the contracts/ negotiate, and difficult to monitor and enforce the covenants/ contracts

Question 16

Which of the following types of firms likely have the highest debt ratios?
A) Investment banks
B) Airplane manufacturers
C) Hotels
D) Consulting firms

Answer 16

B) Airplane manufacturers
C) Hotels

These firms have more a larger pool of tangible assets = higher collateral

Question 17

Unprofitable firms ought to have higher debt ratios

True/ False

Answer 17

False:
Unprofitable firms ought to rely primarily n equity financing since it is risky/ expensive to raise debt due to the lack of profitability

Question 18

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

Answer 18

False:
D) Financial slack can be disadvantageous since it decreases liquidity

Question 19

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

Answer 19

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