Arizona State University ACC 430 Chapter 16 - Financial Distress, Managerial Incentives, and Information

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 firm's 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 Explanatio n: A) B) C) D) Diff: 1 Topic: 16.1 Default and Bankruptcy in a Perfect Market 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 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 : B Explanatio n: A) B) C) D) Diff: 2 Topic: 16.1 Default and Bankruptcy in a Perfect Market Skill: ConceptualUse 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 MI's equity without leverage is closest to: A) $133 million B) $147 million C) $140 million D) $150 million Answer : C Explanatio n: A) B) C) VU = 1/ 3(100) 1/ 3(150) 1/ 3(191) 1.05   = $140 million D) Diff: 1 Topic: 16.1 Default and Bankruptcy in a Perfect Market Skill: Analytical 4) Suppose that MI has zero-coupon debt with a $125 million face value due next year. The initial value of MI's debt is closest to: A) $125 million B)$111 million C) $100 million D) $116 million Answer : B Explanatio n: A) B) Vdebt = 1/ 3(100) 1/ 3(125) 1/ 3(125) 1.05   = $111.11 million C) D) Diff: 2 Topic: 16.1 Default and Bankruptcy in a Perfect Market Skill: Analytical5) Suppose that MI has zero-coupon debt with a $125 million face value due next year. The yield to maturity of MI's debt is closest to: A) 12.5% B) 7.8% C) 25.0% D) 5.0% Answer : A Explanatio n: A) Vdebt = 1/ 3(100) 1/ 3(125) 1/ 3(125) 1.05   = $111.11 million YTM = $125 $111.11 - 1 = . or 12.5% B) C) D) Diff: 2 Topic: 16.1 Default and Bankruptcy in a Perfect Market Skill: Analytical 6) Suppose that MI has zero-coupon debt with a $125 million face value due next year. The expected return of MI's debt is closest to: A) 25.0% B) 12.5% C)5.0% D) 7.8% Answer : C Explanatio n: A) B) C) Vdebt = 1/ 3(100) 1/ 3(125) 1/ 3(125) 1.05   = $111.11 million Expected Return = 1/ 3(100) 1/ 3(125) 1/ 3(125) $111.11   = .05 or 5% D) Diff: 3 Topic: 16.1 Default and Bankruptcy in a Perfect Market Skill: Analytical 7) Suppose that MI has zero-coupon debt with a $125 million face value due next year. The initial value of MI's equity is closest to: A) $30 million B) $15 million C) $29 million D) $24 million Answer : C Explanatio n:A) B) C) VL = 1/ 3(0) 1/ 3(25) 1/ 3(66) 1.05   = $28.89 million D) Diff: 2 Topic: 16.1 Default and Bankruptcy in a Perfect Market Skill: Analytical