Chapter 16 - Finance

Question 1

What is a firms “default” state?

Answer 1

D E F A U L T : a state a firm is in when it fails to make the required interest or principal payments on the debt. After this, debt holders are given certain rights to the assets of the firm. Equity holders can receive dividends but the firm is not obligated to pay them.

Question 2

What happens to share- and debtholders if the firm goes bankrupt?

Answer 2

In bankruptcy, debt holders will receive legal ownership of the firm’s assets, leaving the shareholders with nothing.

Question 3

What is referred to as economic distress?

Answer 3

A significant decline in the value of a firm’s assets, whether or not it experiences financial distress due to leverage.

Question 4

Whats the relation between bankruptcy, debtholders and shareholders?

Answer 4

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.

The total value to all investors does not depend on the firm’s capital structure. Investors as a group are not worse off because a firm has leverage. While bankruptcy results from a firm having leverage, bankruptcy alone does not lead to a greater reduction in the total value to investors. Thus, there is no disadvantage to debt financing

Question 5

What are the two forms of bankruptcy protection?

Answer 5

1. Liquiditation
2. Reorganization

Question 6

What is liquidation?

Answer 6

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 creditors and the firm ceases to exist.

Question 7

What is reorganization?

Answer 7

All pending collection attempts are automatically suspended, and the firm’s existing management is given the opportunity to propose a reorganization plan, while management continues to operate the business. The plan specifies the treatment of each creditor of the firm. The creditors must accept the plan through voting and it must be approved by the bankruptcy court. Not accepted means liquidation.

Question 8

What are the direct costs of bankruptcy?

Answer 8

When a firm is in financial distress, outside professionals (legal and accounting, consultants, appraisers, auctioneers, etc…) will be hired. These costs will reduce the value of the assets that the firm’s investors will receive.

Question 9

What is referred to as a workout?

Answer 9

When a financially distressed firm is successful at reorganizing outside of bankruptcy: the direct costs of bankruptcy should not exceed the cost of a workout.

Question 10

What is a prepackaged bankruptcy?

Answer 10

The firm will first develop a reorganization plan with the agreement of its main creditors and then file Chapter 11 to implement the plan (and pressure any creditors who attempt to hold out for better terms. The firm emerges from bankruptcy quickly and with minimal direct costs.

Question 11

What are the indirect costs of bankruptcy?

Answer 11

-Loss of Customers
-Loss of suppliers
-Loss of Employees.
-Loss of Receivables
-Fire Sales of Assets
-Inefficient Liquidation
-Cost of Creditors

–>Indirect costs are mostly higher than direct costs

Question 12

Who pays for the distress costs of a bankrupt company?

Answer 12

When securities are fairly priced, the original shareholders of a firm pay the present value of the costs associated with bankruptcy and financial distress.

Question 13

Whats the concept of the trade off theory?

Answer 13

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.

Question 14

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.

Answer 14

B

Question 15

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%

Answer 15

D) Debt holders will need to be at least as well off as if the firm went into liquidation. In liquidation the debt holders would receive $450 million, however if the firm continues to operate it will have a value of $500 million. Therefore,
$450 million = percent ownership for debt holders × $500 total value. Solving for percent ownership gives $450/$500 = 90%

Question 16

Suppose that you have received two job offers. Rearden Metal offers you a contract for $75,000 per year for the next two years while Wyatt Oil offers you a contract for $90,000 per year for the next two years. Both jobs are equivalent. Suppose that Rearden Metal’s contract is certain, but Wyatt Oil has a 60% chance of going bankrupt at the end of the year. In the event that Wyatt Oil files for bankruptcy, it will cancel your contract and pay you the lowest amount possible for you to not quit. If you do quit, you expect you could find an new job paying $75,000 per year, but you would be unemployed for four months while searching for this new job.
2) 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

Answer 16

B) If you quit, you will be out of work for 4 months searching for a job leaving 8
months of employment at $75,000 per year or 8/12 × $75,000 = $50,000

Question 17

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 17

B) PVRearden = 75000/1,06^1 + 75000/1,06^2

Question 18

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.

Answer 18

D

Question 19

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 19

A)
Chapter 7 & 13

Question 20

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.

Answer 20

B

Question 21

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.

Answer 21

B

Question 22

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.

Answer 22

D

Question 23

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

Answer 23

A

Question 24

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.

Answer 24

A

Question 25

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.

Answer 25

A

Question 26

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 τD, 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.

Answer 26

C