Question 1

Which one of the following claims on a firm would be paid first in a bankruptcy liquidation if the court adheres to the absolute priority rule?

Accepted Answer

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Question 2

Which one of the following statements is correct concerning a Chapter 7 bankruptcy?

Accepted Answer

In a Chapter 7 bankruptcy, a trustee is appointed to take control of the firm's assets and liquidate them to pay off creditors. This is done in an orderly and fair manner, and the firm is typically dissolved after all assets have been sold and debts have been paid. The other options are incorrect: A is referring to Chapter 11 bankruptcy, C is incorrect because a firm can file for Chapter 7 voluntarily, D is incorrect because administrative costs are paid first, and E is incorrect because issuing new shares of stock is not typically part of Chapter 7 bankruptcy proceedings.

Question 3

Issuing debt instead of new equity in a closely held firm more likely causes owner-managers to:

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Question 4

Which one of these describes a bankruptcy situation known as a "cram down"?

Accepted Answer

A "cram down" is a situation where creditors are forced to accept a bankruptcy plan that they voted to reject. This can happen if the court finds the plan to be fair and equitable, even if some creditors disagree. The term "cram down" comes from the idea that the plan is being forced on the dissenting creditors, who are getting "crammed down" into accepting it.

Question 5

A valuable firm will tend to:

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Question 6

Which one of these statements most applies to a firm that is suffering from financial distress?

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Question 7

Which one of these relationships will exist if a firm is operating under its optimal capital structure?

Accepted Answer

When a firm operates under its optimal capital structure, the present value of the financial distress costs will equal the present value of the tax shield on debt. This means that the benefits of taking on debt (tax shield) will be equal to the costs associated with financial distress. This is when the firm has achieved the perfect balance of debt and equity financing. The other options are not necessarily true when a firm operates under its optimal capital structure.

Question 8

Which of these represent a payment of a nonmarketed claim on a firm's cash flows?
I.Payment of a customer's liability claim
II.Principal repayment of a bond
III.Federal corporate tax payment
IV.Dividend payment

Accepted Answer

Nonmarketed claims are obligations that do not have a secondary market. A customer's liability claim and federal corporate tax payment are nonmarketed claims on a firm's cash flows.

Question 9

Which one of these statements is correct for a levered firm?

Accepted Answer

The optimal level of debt for a firm results in the value of that firm being maximized. This is because there is a tax shield benefit associated with debt, which can increase the firm's cash flows and ultimately its value. However, if a firm has too much debt, it can increase the risk of financial distress and bankruptcy, which can ultimately decrease the value of the firm. Therefore, finding the optimal level of debt is important in maximizing the value of a levered firm.

Question 10

Which one of these statements is correct?

Accepted Answer

The value of a firm's marketed claims can change with changes in the firm's capital structure. This is because the capital structure of a firm affects the riskiness of its stocks and bonds, which in turn affects their value in the market. Therefore, changes in the capital structure can impact the value of a firm's marketed claims. None of the other statements are correct.

Question 11

Which one of these best describes the relationship between bondholders and stockholders at a time when it appears the firm may be facing increased financial distress?

Accepted Answer

In times of financial distress, bondholders tend to prioritize the safety of their investment and may push for the firm to avoid new and risky projects, which can hurt the firm's profitability and, ultimately, the value of stockholders' investments. Stockholders, on the other hand, may be more incentivized to take risks in order to increase the value of their investment, which can further harm bondholders. Therefore, there can be a conflict of interest between bondholders and stockholders, with stockholders potentially underinvesting in order to preserve their own interests.

Question 12

Which one of these actions by a firm is an example of milking the property? Assume the firm is in a period of financial distress.

Accepted Answer

Paying an extra dividend is an action of milking the property. It means that the firm is distributing more cash to shareholders than it can afford in a period of financial distress. This may lead to further financial problems in the future if the firm does not generate sufficient cash flow to cover its operational needs.

Question 13

Which one of the following is true?

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Question 14

A firm may file for Chapter 11 bankruptcy:
I.in an attempt to gain a competitive advantage.
II.using a prepack.
III.while allowing the current management to continue running the firm.
IV.even though it is not insolvent.

Accepted Answer

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Question 15

Conflicts of interest between stockholders and bondholders are known as:

Accepted Answer

Agency costs arise due to conflicts of interest between different parties in a corporation, such as between stockholders and bondholders. These conflicts can lead to decisions that benefit one group at the expense of another.

Question 16

Which of the following are common loan covenants? Assume each item applies only during the term of the loan.
I.Limit on future borrowing
II.Requirement that the borrower maintains a minimum stated level of net working capital
III.Limit on any sales or switches of assets
IV.Limit on the amount of dividends that can be paid

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Question 17

The free cash flow hypothesis supports:

Accepted Answer

The free cash flow hypothesis suggests that increasing debt can reduce the amount of free cash flow available to managers, thus reducing the potential for wasteful spending and encouraging more disciplined financial management.

Question 18

The protective covenants contained within a loan agreement:

Accepted Answer

Protective covenants can increase the value of the borrowing firm by reassuring the lender that the borrower is taking steps to manage risk and ultimately protect the lender's investment. This can result in lower interest rates for the borrower and improved borrowing terms, which can in turn increase the value of the firm.

Question 19

The pecking order states how financing should be raised.In order to avoid asymmetric information problems and misinterpretation of whether management is sending a signal on security overvaluation the firm's first rule is to:

Accepted Answer

The best choice is to use internal financing prior to external financing. This is because external financing (i.e. issuing debt or equity) can be costly due to interest rates, fees, and dilution of ownership. By using internal financing, such as retained earnings, the firm can avoid these costs and maintain control over the company. Additionally, using internal financing can help signal to investors that the firm is financially stable and does not need to rely on external financing.

Question 20

A firm is technically insolvent when:

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Quiz 15: Capital Structure: Limits to the Use of Debt