I wanted to ask a question regarding questions 12 and 13, under section 16.4 of the file I uploaded. In question 12, we had to calculate the value of the firm without leverage. In question 13 we had to calculate the value of the firm with leverage. The formula used in question 13 is the sum of the value of the unlevered firm and the present value of the interest tax shield. I did not understand why in question 12 we used a cash flow of 48 to compute the value of the firm without leverage, whereas in question 13, we used a value of 40 for the free cash flow, in calculating the value of the firm without leverage. Personally, I found answer A to be the correct one. Could you please explain me why the correct answer is B, and why they took a cash flow of 40 in computing the value of the firm without leverage in question 13?

Chapter 16 Financial Distress, Managerial Incentives, and Information 16.1 Default and Bankruptcy in a Perfect Market 1) Which of the following statements is false? A) Equity holders expect to receive dividends and the firm is legally obligated to pay them. B) A firm that fails to make the required interest or principal payments on the debt is in default. C) In the extreme case, the debt holders take legal ownership of the firms assets through a process called bankruptcy. D) After a firm defaults, debt holders are given certain rights to the assets of the firm. Answer: A Diff: 1 Skill: Conceptual 2) 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 firms assets and liabilities. C) Economic distress is a significant decline in the value of a firms assets, whether or not it experiences financial distress due to leverage. D) Modigliani and Millers results continue to hold in a perfect market even when debt is risky and the firm may default. Answer: B Diff: 2 Skill: Conceptual Chapter 16 Financial Distress, Managerial Incentives, and Information 435 Use the information for the question(s) below. Monsters Incorporated (MI) in ready to launch a new product. Depending upon the success of this product, MI will have a value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%. Assume that the capital markets are perfect. 3) The initial value of MIs equity without leverage is closest to: A) $133 million B) $147 million C) $140 million D) $150 million Answer: C Explanation: C) V U = 1/3(100) + 1/3(150) + 1/3(191) = $140 million 1.05 Diff: 1 Skill: Analytical 4) Suppose that MI has zero-coupon debt with a $125 million face value due next year. The initial value of MIs debt is closest to: A) $125 million B) $111 million C) $100 million D) $116 million Answer: B Explanation: Diff: 2 Skill: Analytical B) V debt = 1/3(100) + 1/3(125) + 1/3(125) = $111.11 million 1.05 436 Berk/DeMarzo Corporate Finance 5) Suppose that MI has zero-coupon debt with a $125 million face value due next year. The yield to maturity of MIs debt is closest to: A) 12.5% B) 7.8% C) 25.0% D) 5.0% Answer: A Explanation: A) V debt = YTM = 1/3(100) + 1/3(125) + 1/3(125) = $111.11 million 1.05 $125 - 1 = .125011 or 12.5% $111.11 Diff: 2 Skill: Analytical 6) Suppose that MI has zero-coupon debt with a $125 million face value due next year. The expected return of MIs debt is closest to: A) 25.0% B) 12.5% C) 5.0% D) 7.8% Answer: C Explanation: C) V debt = 1/3(100) + 1/3(125) + 1/3(125) = $111.11 million 1.05 Expected Return = 1/3(100) + 1/3(125) + 1/3(125) = .05 or 5% $111.11 Diff: 3 Skill: Analytical 7) Suppose that MI has zero-coupon debt with a $125 million face value due next year. The initial value of MIs equity is closest to: A) $30 million B) $15 million C) $29 million D) $24 million Answer: C Explanation: Diff: 2 Skill: Analytical C) V L = 1/3(0) + 1/3(25) + 1/3(66) = $28.89 million 1.05 Chapter 16 Financial Distress, Managerial Incentives, and Information 437 8) Suppose that MI has zero-coupon debt with a $125 million face value due next year. The total value of MI with leverage is closest to: A) $133 million B) $140 million C) $147 million D) $125 million Answer: B Explanation: B) V L = 1/3(0) + 1/3(25) + 1/3(66) = $28.89 million 1.05 V debt = 1/3(100) + 1/3(125) + 1/3(125) = $111.11 million 1.05 Total Value = V L + V debt = $28.89 + $111.11 = $140 million Diff: 2 Skill: Analytical Use the information for the question(s) below. Kinston Enterprises has no debt and a debt obligation of $47 million that is due now. The market value of Kinstons assets is $102 million, and the firm has no other liabilities. Assume that capital markets are perfect and that Kinston has 5 million shares outstanding. 9) Kinstons current share price is closest to: A) $20.40 B) $9.40 C) $11.00 D) $10.00 Answer: C Explanation: Diff: 1 Skill: Analytical C) Price = $102M - $47M = $11.00 per share 5M Shares 438 Berk/DeMarzo Corporate Finance 10) The number of new shares that Kinston must issue to raise the capital needed to pay its debt obligation is closest to: A) 4.3 million B) 4.7 million C) 5.0 million D) 4.0 million Answer: A Explanation: D) Price = $102M - $47M = $11.00 per share 5M Shares Number of Shares = $47 million = 4,272,728 shares $11.00 Diff: 2 Skill: Analytical Use the information for the question(s) below. Monsters Incorporated (MI) in ready to launch a new product. Depending upon the success of this product, MI will have a value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%. Assume that the capital markets are perfect. 11) Suppose that MI has zero-coupon debt with a $140 million face value due next year. Calculate the value of levered equity, the value of debt, and the total value of MI with leverage. Answer: V L = 1/3(0) + 1/3(10) + 1/3(51) = $19.37 million 1.05 V debt = 1/3(100) + 1/3(140) + 1/3(140) = $120.63 million 1.05 Total Value = V L + V debt = $19.37 + $120.63 = $140 million Diff: 2 Skill: Analytical Chapter 16 Financial Distress, Managerial Incentives, and Information 439 16.2 The Costs of Bankruptcy and Financial Distress 1) Which of the following statements is false? A) When a firm fails to make a required payment to debt holders, it is in bankruptcy. B) 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. C) Bankruptcy is a long and complicated process that imposes both direct and indirect costs on the firm and its investors that the assumption of perfect capital markets ignores. D) Bankruptcy is rarely simple and straightforward-equity holders don't just \"hand the keys\" to debt holders the moment the firm defaults on a debt payment. Answer: A Diff: 1 Skill: Conceptual 2) 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: D Diff: 1 Skill: Conceptual 3) 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: A Diff: 2 Skill: Conceptual 440 Berk/DeMarzo Corporate Finance 4) 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: B Diff: 2 Skill: Conceptual 5) Which of the following statements is false? A) Whether paid by the firm or its creditors, the indirect costs of bankruptcy increase the value of the assets that the firm's investors will ultimately receive. B) In addition to the money spent by the firm, the creditors may incur costs during the bankruptcy process. C) The bankruptcy code is designed to provide an orderly process for settling a firm's debts. D) To ensure that their rights and interests are respected, and to assist in valuing their claims in a proposed reorganization, creditors may seek separate legal representation and professional advice. Answer: A Diff: 2 Skill: Conceptual 6) 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: B Diff: 2 Skill: Conceptual Chapter 16 Financial Distress, Managerial Incentives, and Information 441 7) Which of the following statements is false? A) Although indirect costs of bankruptcy are difficult to measure accurately, they are typically much smaller than the direct costs of bankruptcy. B) Bankruptcy protection can be used by management to delay the liquidation of a firm that should be shut down. C) Because many aspects of the bankruptcy process are independent of the size of the firm, the costs are typically higher, in percentage terms, for smaller firms. D) Aside from the direct legal and administrative costs of bankruptcy, many other indirect costs are associated with financial distress (whether or not the firm has formally filed for bankruptcy). Answer: A Diff: 2 Skill: Conceptual 8) 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 sellers continued success. Answer: D Diff: 2 Skill: Conceptual 9) 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: A Diff: 1 Skill: Conceptual 10) Which of the following is not an indirect cost of bankruptcy? A) Loss of Suppliers B) Fire Sales of Assets C) Costs of Appraisers D) Loss of Employees Answer: C Diff: 1 Skill: Conceptual 442 Berk/DeMarzo Corporate Finance 11) Which of the following is not a direct cost of bankruptcy? A) Costs to Creditors B) Investment Banking Costs C) Costs of accounting experts D) Legal Costs and Fees Answer: A Diff: 1 Skill: Conceptual 12) List five general categories of indirect costs associated with bankruptcy. Answer: Indirect Costs: Costs to Creditors Loss of Customers Loss of Suppliers Loss of Employees Loss of Receivables Fire Sales of Assets Delayed Liquidation Diff: 1 Skill: Conceptual 16.3 Financial Distress Costs and Firm Value 1) Which of the following statements is false? A) Debt holders are not foolishthey recognize that when the firm defaults, they will not be able to get the full value of the assets. As a result, they will pay less for the debt initially. B) The costs of financial distress represent an important departure from Modigliani and Millers assumption of perfect capital markets. C) Levered firms risk incurring financial distress costs that reduce the cash flows available to investors. D) When securities are fairly priced, the original shareholders of a firm pay the future value of the costs associated with bankruptcy and financial distress. Answer: D Diff: 1 Skill: Conceptual Chapter 16 Financial Distress, Managerial Incentives, and Information 443 Use the information for the question(s) below. Monsters Incorporated (MI) in ready to launch a new product. Depending upon the success of this product, MI will have a value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%. Assume that the capital markets are perfect. 2) Assuming that in the event of default, 20% of the value of MIs assets will be lost in bankruptcy costs, the initial value of MIs equity without leverage is closest to: A) $150 million B) $147 million C) $140 million D) $133 million Answer: C Explanation: C) V U = 1/3(100) + 1/3(150) + 1/3(191) = $140 million 1.05 Diff: 1 Skill: Analytical 3) Assume that in the event of default, 20% of the value of MIs assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face value due next year. The initial value of MIs debt is closest to: A) $110 million B) $105 million C) $125 million D) $111 million Answer: B Explanation: Diff: 2 Skill: Analytical B) V debt = 1/3(100(1 - .20)) + 1/3(125) + 1/3(125) = $104.76 million 1.05 444 Berk/DeMarzo Corporate Finance 4) Assume that in the event of default, 20% of the value of MIs assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face value due next year. The yield to maturity of MIs debt is closest to: A) 13.75% B) 5.00% C) 19.25% D) 12.50% Answer: C Explanation: C) V debt = YTM = 1/3(100(1 - .20)) + 1/3(125) + 1/3(125) = $104.76 million 1.05 $125 - 1 = .193182 or 19.3% $104.76 Diff: 2 Skill: Analytical 5) Assume that in the event of default, 20% of the value of MIs assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face value due next year. The initial value of MIs equity is closest to: A) $30 million B) $29 million C) $15 million D) $24 million Answer: B Explanation: Diff: 2 Skill: Analytical B) V L = 1/3(0) + 1/3(25) + 1/3(66) = $28.89 million 1.05 Chapter 16 Financial Distress, Managerial Incentives, and Information 445 6) Assume that in the event of default, 20% of the value of MIs assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face value due next year. The total value of MI with leverage is closest to: A) $140 million B) $100 million C) $125 million D) $134 million Answer: D Explanation: D) V L = 1/3(0) + 1/3(25) + 1/3(66) = $28.89 million 1.05 V debt = 1/3(100(1 - .20)) + 1/3(125) + 1/3(125) = $104.76 million 1.05 Total Value = V L + V debt = $28.89 + $104.76 = $133.65 million Diff: 2 Skill: Analytical 7) Assume that in the event of default, 20% of the value of MIs assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face value due next year. The present value of MIs financial distress costs is closest to: A) $20.0 million B) $6.6 million C) $6.3 million D) $19.0 million Answer: C Explanation: Diff: 2 Skill: Analytical C) PV(Financial Distress Costs) = 1/3(20) + 1/3(0) + 1/3(0) = $6.349 million 1.05 446 Berk/DeMarzo Corporate Finance 8) Assume that in the event of default, 20% of the value of MIs assets will be lost in bankruptcy costs. Suppose that at the start of the year, MI has no debt outstanding, but has 5.6 million shares of stock outstanding. If MI does not issue debt, its share price is closest to: A) $5.15 B) $23.75 C) $23.90 D) $25.00 Answer: D Explanation: D) V U = 1/3(100) + 1/3(150) + 1/3(191) = $140 million 1.05 Price per Share = $140M / 5.6 million shares = $25.00 Diff: 1 Skill: Analytical 9) Assume that in the event of default, 20% of the value of MIs assets will be lost in bankruptcy costs. Suppose that at the start of the year, MI has no debt outstanding, but has 5.6 million shares of stock outstanding. If MI issues debt of $125 million due next year and uses the proceeds to repurchase shares, the share price following the announcement of the repurchase will be closest to: A) $23.90 B) $23.75 C) $25.00 D) $5.15 Answer: A Explanation: A) V L = 1/3(0) + 1/3(25) + 1/3(66) = $28.89 million 1.05 V debt = 1/3(100(1 - .20)) + 1/3(125) + 1/3(125) = $104.76 million 1.05 Total Value = V L + Vdebt = $28.89 + $104.76 = $133.65 million Price per Share = $133.65M / 5.6 million shares = $23.87 Diff: 3 Skill: Analytical Chapter 16 Financial Distress, Managerial Incentives, and Information 447 10) Assume that in the event of default, 20% of the value of MIs assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $140 million face value due next year. Calculate the value of levered equity, the value of debt, and the total value of MI with leverage. Answer: V L = 1/3(0) + 1/3(10) + 1/3(51) = $19.37 million 1.05 V debt = 1/3(100(1 -.20)) + 1/3(140) + 1/3(140) = $114.29 million 1.05 Total Value = V L + V debt = $19.37 + $114.29 = $133.66 million Diff: 3 Skill: Analytical 16.4 Optimal Capital Structure: The Tradeoff Theory 1) 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: A Diff: 1 Skill: Conceptual 2) Which of the following statements is false? A) Calculating the precise present value of financial distress costs is a relatively straightforward process. B) Two key qualitative factors determine the present value of financial distress costs: (1) the probability of financial distress and (2) the magnitude of the costs after a firm is in distress. C) Technology firms are likely to incur high costs when they are in financial distress, due to the potential for loss of customers and key personnel, as well as a lack of tangible assets that can be easily liquidated. D) The magnitude of the financial distress costs will depend on the relative importance of the sources of these costs and is likely to vary by industry. Answer: A Diff: 1 Skill: Conceptual 448 Berk/DeMarzo Corporate Finance 3) 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 *D, where * 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: C Diff: 2 Skill: Conceptual 4) Which of the following statements is false? A) Firms with steady, reliable cash flows, such as utility companies, are able to use high levels of debt and still have a very low probability of default. B) If there were no costs of financial distress, the value of the firm would continue to increase with increasing debt until the interest on the debt exceeds the firm's earnings before interest and taxes and the tax shield is exhausted. C) The costs of financial distress reduce the value of the levered firm, V L. The amount of the reduction decreases with the probability of default, which in turn increases with the level of the debt D. D) The tradeoff theory states that firms should increase their leverage until it reaches the level D* for which V L is maximized. Answer: C Diff: 2 Skill: Conceptual 5) Which of the following statements is false? A) The presence of financial distress costs can explain why firms choose debt levels that are too high to fully exploit the interest tax shield. B) With higher costs of financial distress, it is optimal for the firm to choose lower leverage. C) Differences in the magnitude of financial distress costs and the volatility of cash flows can explain the differences in the use of leverage across industries. D) At the point D*, where V L is maximized, the tax savings that result from increasing leverage are just offset by the increased probability of incurring the costs of financial distress. Answer: A Diff: 2 Skill: Conceptual Chapter 16 Financial Distress, Managerial Incentives, and Information 449 6) Which of the following industries is likely to have the lowest costs of financial distress? A) Airlines B) Computer Software C) Biotechnology D) Electric Utilities Answer: D Diff: 1 Skill: Conceptual 7) Which of the following industries likely to have the highest costs of financial distress? A) Grocery store B) Semiconductors C) Real estate D) Utilities Answer: B Diff: 1 Skill: Conceptual Use the information for the question(s) below. Big Blue Banana (BBB) is a clothing retailer with a current share price of $10.00 and with 25 million shares outstanding. Suppose that Big Blue Banana announces plans to lower its corporate taxes by borrowing $100 million and using the proceeds to repurchase shares. 8) Assuming perfect capital markets, the share price for BBB after this announcement is closest to: A) $11.40 B) $10.85 C) $10.00 D) $8.60 Answer: C Explanation: Diff: 1 Skill: Analytical C) In perfect capital markets, V L = VU so even with the announcement of the increase in leverage the stock price wont change. 450 Berk/DeMarzo Corporate Finance 9) Suppose that BBB pays corporate taxes of 35% and that shareholders expects the change in debt to be permanent. Assuming that capital markets are perfect except for the existence of corporate taxes, the share price for BBB after this announcement is closest to: A) $10.00 B) $10.85 C) $8.60 D) $11.40 Answer: D Explanation: D) V U = $10.00 25 million shares = $250 million V L = VU + cB = $250 + .35($100) = $285 million / 25 million shares = $11.40 Diff: 2 Skill: Analytical 10) Suppose that BBB pays corporate taxes of 35% and that shareholders expects the change in debt to be permanent. Assume that capital markets are perfect except for the existence of corporate taxes and financial distress costs. If the price of BBBs stock rises to $10.85 per share following the announcement , then the present value of BBBs financial distress costs is closest to: A) $21.25 million B) $35.00 million C) $11.40 million D) $13.75 million Answer: D Explanation: D) VU = $10.00 25 million shares = $250 million V L = V U + cB = $250 + .35($100) = $285 million / 25 million shares = $11.40 PV of financial distress costs = ($11.40 - $10.85) 25 million shares = $13.75 million Diff: 2 Skill: Analytical Chapter 16 Financial Distress, Managerial Incentives, and Information 451 Use the information for the question(s) below. Luther Industries has no debt and expects to generate free cash flows of $48 million each year. Luther believes that if it permanently increases its level of debt to $100 million, the risk of financial distress may cause it to lose some customers and receive less favorable terms from its suppliers. As a result, Luthers expected free cash flows with debt will be only $44 million per year. Suppose Luthers tax rate is 40%, the risk -free rate is 6%, the expected return of the market is 14%, and the beta of Luthers free cash flows is 1.25 (with or without leverage). 11) The value of Luther without leverage is closest to: A) $315 million B) $300 million C) $205 million D) $340 million Answer: B Explanation: B) RE = rf - (rM - rf) = .06 + 1.25(.14 - .06) = .16 V U = FCF $48 = = $300 million rE .16 Diff: 2 Skill: Analytical 12) The value of Luther with leverage is closest to: A) $315 million B) $340 million C) $205 million D) $300 million Answer: A Explanation: A) RE = rf - (rM - rf) = .06 + 1.25(.14 - .06) = .16 V U = FCF $40 = = $275 million (using lower cash flow from leverage) rE .16 V L = VU + cD = $275 + .4($100) = $315 Diff: 2 Skill: Analytical 452 Berk/DeMarzo Corporate Finance Use the information for the question(s) below. Big Blue Banana (BBB) is a clothing retailer with a current share price of $10.00 and with 25 million shares outstanding. Suppose that Big Blue Banana announces plans to lower its corporate taxes by borrowing $100 million and using the proceeds to repurchase shares. 13) Suppose that BBB pays corporate taxes of 40% and that shareholders expects the change in debt to be permanent. Assume that capital markets are perfect except for the existence of corporate taxes and financial distress costs. If the price of BBBs stock rises to $10.80 per share following the announcement, then the present value of BBBs financial distress costs is closest to: Answer: VU = $10.00 25 million shares = $250 million V L = V U + cB = $250 + .40($100) = $290 million / 25 million shares = $11.60 PV of financial distress costs = ($11.60 - $10.80) 25 million shares = $20 million Diff: 2 Skill: Analytical 16.5 Exploiting Debt Holders: The Agency Costs of Leverage 1) Which of the following statements is false? A) When a firm faces financial distress, creditors can gain by making sufficiently risky investments, even if they have negative NPV. B) When a firm has leverage, a conflict of interest exists if investment decisions have different consequences for the value of equity and the value of debt. C) In some circumstances, managers may take actions that benefit shareholders but harm the firm's creditors and lower the total value of the firm. D) Agency costs are costs that arise when there are conflicts of interest between stakeholders. Answer: A Diff: 1 Skill: Conceptual 2) Which of the following statements is false? A) When a firm faces financial distress, shareholders have an incentive not to invest and to withdraw money from the firm if possible. B) Because top managers often hold shares in the firm and are hired and retained with the approval of the board of directors, which itself is elected by shareholders, managers will generally make decisions that increase the value of the firm's equity. C) An over-investment problem occurs when shareholders have an incentive to invest in risky positive-NPV projects. D) A negative-NPV project destroys value for the firm overall. Answer: C Diff: 1 Skill: Conceptual Chapter 16 Financial Distress, Managerial Incentives, and Information 453 3) Which of the following statements is false? A) The agency costs of debt can arise only if there is no chance the firm will default and impose losses on its debt holders. B) Agency costs represent another cost of increasing the firm's leverage that will affect the firms optimal capital structure choice. C) An under-investment problem occurs when shareholders choose to not invest in a positive-NPV project. D) When a firm faces financial distress, it may choose not to finance new, positive-NPV projects. Answer: A Diff: 2 Skill: Conceptual 4) Which of the following statements is false? A) Creditors often place restrictions on the actions that the firm can take. Such restrictions are referred to as debt covenants. B) Covenants are often designed to prevent management from exploiting debt holders, so they may help to reduce agency costs. C) Agency costs are smallest for long-term debt. D) Covenants may limit the firms ability to pay large dividends or the types of investments that the firm can make. Answer: C Diff: 2 Skill: Conceptual Use the information for the question(s) below. JR Industries has a $20 million loan due at the end of the year and under its current business strategy its assets will have a market value of only $15 million when the loan comes due. JR is considering a new much riskier business strategy. While this new riskier strategy can be implemented using JRs existing assets without any additional investment, the new strategy has only a 40% probability of succeeding. If the new strategy is a success, the market value of JRs assets will be $30, but if the strategy fails the assets will be worth only $5 million. 5) What is the overall expected payoff under JRs new riskier business strategy? A) $4 million B) $11 million C) $20 million D) $15 million Answer: D Explanation: Diff: 1 Skill: Analytical D) Expected payoff = (.4)$30 + (.6)$5 = $15 million 454 Berk/DeMarzo Corporate Finance 6) What is the expected payoff to debt holders under JRs new riskier business strategy? A) $20 million B) $4 million C) $15 million D) $11 million Answer: D Explanation: D) Expected payoff = (.4)$20 + (.6)$5 = $11 million Diff: 1 Skill: Analytical 7) What is the expected payoff to equity holders under JRs new riskier business strategy? A) $15 million B) $11 million C) $20 million D) $4 million Answer: D Explanation: D) Expected payoff = (.4)$10 + (.6)$0 = $4 million Diff: 1 Skill: Analytical Use the information for the question(s) below. Wildcat Drilling is an oil and gas exploration company that currently operating two active oil fields with a market value of $200 million dollars each. Unfortunately, Wildcat Drilling has $500 million in debt coming due at the end of the year. A large oil company has offered Wildcat drilling a highly speculative, but potentially very valuable, oil and gas lease in exchange for one of their active oil fields. If Wildcat accepts the trade, there is a 10% chance that Wildcat will discover a major new oil field that would be worth $1.2 billion, a 15% that Wildcat will discover a productive oil field that would be worth $600 million, and a 75% chance that Wildcat will not discover oil at all. 8) What is the overall expected payoff to Wildcat from the speculative oil lease deal? A) $360 million B) $275 million C) $85 million D) $160 million Answer: A Explanation: Diff: 2 Skill: Analytical A) Expected payoff = (.1)($1200 ) + (.15)($600) + (.75)($200) = $360 million Chapter 16 Financial Distress, Managerial Incentives, and Information 455 9) What is the expected payoff to debt holders with the speculative oil lease deal? A) $10 million B) $275 million C) $85 million D) $160 million Answer: B Explanation: B) Expected payoff = (.1)($500) + (.15)($500) + (.75)($200) = $275 million Diff: 2 Skill: Analytical 10) What is the expected payoff to equity holders with the speculative oil lease deal? A) $10 million B) $160 million C) $275 million D) $85 million Answer: D Explanation: D) Expected payoff = (.1)($1200 - $500) + (.15)($600 - $500) + (.75)($0) = $85 million Diff: 2 Skill: Analytical 11) Rose Industries has a $20 million loan due at the end of the year and its assets will have a market value of only $15 million when the loan comes due. Currently Rose has $2 million in cash. Rose is considering two possible alternative uses for this cash. One possibility is to pay the $2 million out to shareholders in the form of a special dividend. The second possibility is to invest the $2 million into a project that offers a $4 million NPV. What are the payoffs to the debt and equity holders under each of the two alternatives? Which alternative would equity holders prefer? Which alternative would debt holders prefer? What is the economic term that describes this situation? Answer: Case #1 Pay special dividend Payoff to equity holders = $2 million Payoff to debt holders = $15 million - $2 million = $13 million Case #2 Invest in Positive NPV project Payoff to equity holders = $0 Payoff to debt holders = $15 million + $4 million = $19 million So debt holders prefer +NPV project and equity holders prefer special dividend. This is an under investment problem, where a firm does not engage in a + NPV project because of agency costs between shareholders and debt holders. Diff: 2 Skill: Analytical 456 Berk/DeMarzo Corporate Finance 16.6 Motivating Managers: The Agency Benefits of Leverage 1) Which of the following statements is false? A) One disadvantage of using leverage is that it does not allow the original owners of the firm to maintain their equity stake. B) The separation of ownership and control creates the possibility of management entrenchment; facing little threat of being fired and replaced, managers are free to run the firm in their own best interests. C) Managers also have their own personal interests, which may differ from those of both equity holders and debt holders. D) The costs of reduced effort and excessive spending on perks are another form of agency cost. Answer: A Diff: 1 Skill: Conceptual 2) Which of the following statements is false? A) A serious concern for large corporations is that managers may make large, unprofitable investments. B) While overspending on personal perks may be a problem for large firms, these costs are likely to be small relative to the overall value of the firm. C) Some financial economists explain a managers willingness to engage in negative -NPV investments as empire building. D) While ownership is often diluted for small, young firms, ownership typically becomes concentrated over time as a firm grows. Answer: D Diff: 1 Skill: Conceptual 3) Which of the following statements is false? A) Leverage can reduce the degree of managerial entrenchment because managers are more likely to be fired when a firm faces financial distress. B) When a firm is highly levered, creditors themselves will closely monitor the actions of managers, providing an additional layer of management oversight. C) According to the empire building hypothesis, leverage increases firm value because it commits the firm to making future interest payments, thereby reducing excess cash flows and wasteful investment by managers. D) Managers of large firms tend to earn higher salaries, and they may also have more prestige and garner greater publicity than managers of small firms. As a result, managers may expand (or fail to shut down) unprofitable divisions, pay too much for acquisitions, make unnecessary capital expenditures, or hire unnecessary employees. Answer: C Diff: 2 Skill: Conceptual Chapter 16 Financial Distress, Managerial Incentives, and Information 457 Use the information for the question(s) below. You own your own firm and you need to raise $50 million to fund an expansion. Following the expansion, your firm will be worth $75 million in its unlevered form. You want to go ahead with the expansion, but you are concerned that you may not be able to maintain ownership of over 50% of your firms equity. In other words, you are concerned that if you use equity to finance the expansion, you may loose control of your firm. 4) Assume that capital markets are perfect, you issue $30 million in new debt, and you issue $20 million in new equity. You ownership stake in the firm following these new issues of debt and equity is closest to: A) 58% B) 50% C) 33% D) 55% Answer: D Explanation: D) Owners equity = value - debt - new equity = 75 - 30 - 20 = $25 million Total equity = owners equity + new equity = $25 + $20 = $45 million $25 Owners stake = = .555555 or 55.56% $45 Diff: 1 Skill: Analytical 5) Assume that capital markets are perfect, you issue $25 million in new debt, and you issue $25 million in new equity. You ownership stake in the firm following these new issues of debt and equity is closest to: A) 50% B) 55% C) 58% D) 33% Answer: A Explanation: Diff: 1 Skill: Analytical A) Owners equity = value - debt - new equity = 75 - 25 - 25 = $25 million Total equity = owners equity + new equity = $25 + $25 = $50 million $25 = .50 or 50.0% Owners stake = $50 458 Berk/DeMarzo Corporate Finance 6) Assume that capital markets are perfect except for the existence of corporate taxes. Your firm pays 40% of earnings in taxes and you decide to issue $25 million in new debt and $25 million in new equity. You ownership stake in the firm following these new issues of debt and equity is closest to: A) 58% B) 55% C) 33% D) 50% Answer: A Explanation: A) V U = $75 million V L = V U + cD = $75 + .40($25) = $85 million Owners equity = value - debt - new equity = 85 - 25 - 25 = $35 million Total equity = owners equity + new equity = $35 + $25 = $60 million $35 Owners stake = = .5833 or 58.33% $60 Diff: 2 Skill: Analytical 7) Assume that capital markets are perfect except for the existence of corporate taxes and that your firm pays 40% of earnings in taxes. If you want to maintain ownership of at least a 50%, then the minimum amount of debt that you must issue to fund the expansion is closest to: A) $19 million B) $18 million C) $16 million D) $20 million Answer: B Explanation: B) V U = $75 million % Ownership = V L - new debt - new equity V L - new debt Given: V L = VU + cD new equity = $50 million needed for expansion - the amount of new debt: % Ownership = $75 + .4(debt) - debt - (50 - debt) $75 + .4(debt) - debt % Ownership = $25 + .4(debt) = .50 (given we want 50% ownership) $75 - .6(debt) $25 + .4(debt) = .50($75 - .6(debt)) 50 + 1.4(debt) = 75 25 = $17.857 million Debt = 1.4 Diff: 3 Skill: Analytical Chapter 16 Financial Distress, Managerial Incentives, and Information 459 8) Assume that capital markets are perfect except for the existence of corporate taxes and that your firm pays 35% of earnings in taxes. If you want to maintain ownership of at least a 50%, then calculate the minimum amount of debt that you must issue to fund the expansion. Answer: V U = $75 million % Ownership = V L - new debt - new equity V L - new debt Given: V L = VU + cD New equity = $50 million needed for expansion - the amount of new debt: % Ownership = $75 + .35(debt) - debt - (50 - debt) $75 + .35(debt) - debt % Ownership = $25 + .35(debt) = .50 (given we want 50% ownership) $75 - .65(debt) $25 + .35(debt) = .50($75 - .65(debt)) 50 + 1.35(debt) = 75 25 = $18.52 million Debt = 1.35 Diff: 3 Skill: Analytical 16.7 Agency Costs and the Tradeoff Theory 1) Which of the following statements is false? A) The optimal level of debt D*, balances the costs and benefits of leverage. B) As the debt level increases, the firm benefits from the interest tax shield (which has present value *D). C) If the debt level is too large firm value is reduced due to the loss of tax benefits (when interest exceeds EBIT), financial distress costs, and the agency costs of leverage. D) As the debt level increases, the firm faces worse incentives for management, which increase wasteful investment and perks. Answer: D Diff: 1 Skill: Conceptual 460 Berk/DeMarzo Corporate Finance 2) Which of the following statements is false? A) Firms with high R&D costs and future growth opportunities typically maintain high debt levels. B) The tradeoff theory explains how firms should choose their capital structures to maximize value to current shareholders. C) With tangible assets, the financial distress costs of leverage are likely to be low, as the assets can be liquidated for close to their full value. D) Proponents of the management entrenchment theory of capital structure believe that managers choose a capital structure to avoid the discipline of debt and maintain their own job security. Answer: A Diff: 2 Skill: Conceptual 3) Which of the following firms is likely to maintain low levels of debt? A) An electric utility B) A tobacco company C) An internet firm D) A mature restaurant chain Answer: C Diff: 1 Skill: Conceptual Use the information for the question(s) below. If it is managed efficiently, Luther industries will have assets with market value of $100 million, $300, million, or $500 million next year, with each outcome being equally likely. Managers may, however, engage in wasteful empire building which will reduce the firms market value by $20 million in all cases. Managers may also increase the risk of the firm, changing the probability of each outcome to 50%, 20%, and 30% respectively. 4) If it is managed efficiently, then the expected market value of Luthers assets is closest to: A) $300 million B) $260 C) $240 D) $280 million Answer: A Explanation: Diff: 1 Skill: Analytical A) Expected value = $100 + $300 + $500 = $300 million 3 Chapter 16 Financial Distress, Managerial Incentives, and Information 461 5) If its managers engage in empire building, then the expected market value of Luthers assets is closest to: A) $260 B) $280 million C) $240 D) $300 million Answer: B Explanation: B) Expected value = 80 + 280 + 480 = $280 million 3 Diff: 1 Skill: Analytical 6) If its managers increase the risk of the firm, then the expected market value of Luthers assets is closest to: A) $260 B) $240 C) $300 million D) $280 million Answer: A Explanation: A) Expected value = .5(100) + .2(300) + .3(500) = $260 million Diff: 1 Skill: Analytical 16.8 Asymmetric Information and Capital Structure 1) The idea that managers who perceive the firms equity is under-priced will have a preference to fund investment using retained earnings, or debt, rather than equity is known as the A) signaling theory of debt. B) lemons principle. C) pecking order hypothesis. D) credibility principle. Answer: C Diff: 1 Skill: Definition 462 Berk/DeMarzo Corporate Finance 2) The idea that claims in ones self-interest are credible only if they are supported by actions that would be too costly to take if the claims were untrue is known as the A) pecking order hypothesis. B) credibility principle. C) lemons principle. D) signaling theory of debt. Answer: B Diff: 1 Skill: Definition 3) The idea that when a seller has private information about the value of good, buyers will discount the price they are willing to pay due to adverse selection is known as the A) pecking order hypothesis. B) signaling theory of debt. C) lemons principle. D) credibility principle. Answer: C Diff: 1 Skill: Definition Use the information for the question(s) below. Electronic Gaming Incorporated (EGI) is a firm with no debt and its 20 million shares are currently trading for $16 per share. Based on the prospects for EGIs new hand held video game, management feels the true value of the firm is $20 per share. Management believes that the share price will reflect this higher value after the video game is released next fall. EGI has already announced plans to raise $100 million from investors to build a new factory. 4) Assume that EGI decides to raise the $100 million through the issuance of new shares prior to the release of the new video game. The number of new shares that EGI will issue is closest to: A) 5.0 million B) 6.25 million C) 10 million D) 1.6 million Answer: B Explanation: Diff: 1 Skill: Analytical B) shares = $100 M = 6,250,000 new shares $16 per share Chapter 16 Financial Distress, Managerial Incentives, and Information 463 5) Assume that EGI decides to wait until after the release of the new video game before they raise the $100 million through the issuance of new shares. The number of new shares that EGI will issue is closest to: A) 1.6 million B) 5.0 million C) 10 million D) 6.25 million Answer: B Explanation: B) shares = $100 M = 5,000,000 new shares $20 per share Diff: 1 Skill: Analytical 6) Assume that EGI decides to raise the $100 million through the issuance of new shares prior to the release of the new video game. EGIs share price following the release of the new video game will be closest to: A) $18.00 B) $19.00 C) $20.00 D) $16.00 Answer: B Explanation: B) shares = $100 M = 6,250,000 new shares $16 per share Total shares = 20M (existing) + 6.25M new = 26.25 million. Total Value = existing value + $100M new factory Total Value = $20 per share (true value) 20 million shares + $100 = $500 million Price per share = Diff: 2 Skill: Analytical $500 = $19.05 26.25 464 Berk/DeMarzo Corporate Finance 7) Assume that EGI decides to wait until after the release of the new video game before they raise the $100 million through the issuance of new shares. EGIs share price following the release of the new video game will be closest to: A) $18.00 B) $20.00 C) $16.00 D) $19.00 Answer: B Explanation: B) shares = $100 M = 5M new shares $20 per share Total shares = 20M (existing) + 5M new = 25 million. Total value = existing value + $100M new factory Total value = $20 per share (true value) 20 million shares + $100 = $500 million Price per share = $500 = $20.00 25 Diff: 2 Skill: Analytical 16.9 Capital Structure: The Bottom Line 1) Which of the following statements is false? A) The most important insight regarding capital structure goes back to Modigliani and Miller: With perfect capital markets, a firms security choice alters the risk of the firm's equity, but it does not change its value or the amount it can raise from outside investors. B) When agency costs are significant, short-term debt may be the most attractive form of external financing. C) Too much debt can motivate managers and equity holders to take excessive risks or over-invest in a firm. D) Of all the different possible imperfections that drive capital structure, the most clear -cut, and possibly the most significant, is taxes. Answer: C Diff: 1 Skill: Conceptual