W3

Question 1

What is financial distress?

Answer 1

A situation where a firm has difficulty meeting its debt obligations.

Question 2

What is default?

Answer 2

When a firm fails to make required interest or principal payments on its debt.

Question 3

What is bankruptcy?

Answer 3

The legal process by which debt holders gain control of a firm’s assets after default.

Question 4

What is the interest tax shield?

Answer 4

The reduction in taxes paid due to the tax deductibility of interest expenses.

Question 5

What is the effective tax advantage of debt?

Answer 5

The tax benefit received by a firm for using debt instead of equity financing.

Question 6

What is the formula for the interest tax shield?

Answer 6

Interest Tax Shield = Corporate Tax Rate × Interest Payments

Question 7

What is the value of the interest tax shield with permanent debt?

Answer 7

Value = Corporate Tax Rate × Value of Debt, where debt is constant and fairly priced.

Question 8

How does the interest tax shield affect firm value?

Answer 8

It increases firm value by the present value of the tax savings from interest payments.

Question 9

What is the modified Modigliani and Miller Proposition I with taxes?

Answer 9

VL = VU + PV(Interest Tax Shield), where VL is the value of a levered firm and VU is the value of an unlevered firm.

Question 10

What is the trade-off theory of capital structure?

Answer 10

The idea that firms balance the tax benefits of debt with the costs of financial distress and agency costs.

Question 11

What factors affect the present value of financial distress costs?

Answer 11

1) Probability of distress, 2) Magnitude of costs, 3) Discount rate used.

Question 12

When does a firm reach optimal capital structure under the trade-off theory?

Answer 12

When the marginal benefit of the interest tax shield equals the marginal cost of financial distress.

Question 13

What is the formula summarizing the trade-off theory?

Answer 13

VL = VU + PV(Interest Tax Shield) − PV(Financial Distress Costs)

Question 14

What are direct costs of bankruptcy?

Answer 14

Legal, accounting, and administrative costs incurred during the bankruptcy process.

Question 15

What are indirect costs of financial distress?

Answer 15

Loss of customers, suppliers, employees, receivables, and forced asset sales.

Question 16

Chapter 7 bankruptcy

Answer 16

Liquidation process in which a trustee sells the firm’s assets to pay creditors.

Question 17

Chapter 11bankruptcy

Answer 17

Reorganization allowing the firm to continue operations while restructuring its obligations.

Question 18

What is a workout?

Answer 18

An out-of-court agreement between a firm and creditors to restructure debt and avoid formal bankruptcy.

Question 19

What is a prepackaged bankruptcy?

Answer 19

A reorganization plan agreed upon in advance with creditors before filing for Chapter 11.

Question 20

What are agency costs?

Answer 20

Costs arising from conflicts of interest between stakeholders, like shareholders and debt holders.

Question 21

What is asset substitution (risk shifting)?

Answer 21

When equity holders choose riskier projects that may benefit them at the expense of debt holders.

Question 22

What is debt overhang?

Answer 22

A situation where existing debt discourages equity holders from funding new positive-NPV projects.

Question 23

What is adverse selection in financing?

Answer 23

When managers have more information than investors and the market interprets equity issuance as bad news.

Question 24

Why doesn’t increasing earnings per share (EPS) through leverage increase firm value?

Answer 24

Because the increased EPS compensates for higher equity risk, leaving share price unchanged.

Question 25

Does issuing equity dilute value for existing shareholders?

Answer 25

No, if the firm raises value-proportionate funds, the share price remains unchanged.

Question 26

What is financial distress in a corporate context?

Answer 26

It refers to a situation where a firm experiences cash flow problems that may prevent it from meeting its debt obligations, potentially leading to default or bankruptcy.

Question 27

What is the difference between economic distress and financial distress?

Answer 27

Economic distress refers to a fundamental decline in the value of a firm’s assets or profitability, while financial distress is about difficulty in meeting debt obligations, which may or may not be due to economic distress.

Question 28

What assumptions are made when valuing the interest tax shield using a perpetuity formula?

Answer 28

The debt is permanent, fairly priced, risk-free, and the corporate tax rate is constant over time.

Question 29

How does debt financing affect taxes at the corporate level?

Answer 29

Interest payments are tax-deductible, reducing taxable income and leading to lower corporate taxes.

Question 30

Why do firms not use 100% debt if interest is tax-deductible?

Answer 30

Because the benefits from tax savings are eventually outweighed by the costs of financial distress and agency problems.

Question 31

Why are indirect costs of financial distress often higher than direct costs?

Answer 31

Because they involve lost sales, damaged reputation, lower employee morale, and disrupted operations, which can have a long-term effect on firm value.

Question 32

What is the free cash flow hypothesis?

Answer 32

It suggests that managers with excess cash may overinvest in negative-NPV projects unless constrained by debt or shareholder pressure.

Question 33

How can debt serve as a disciplinary mechanism for managers?

Answer 33

Debt requires regular payments, reducing free cash flow and forcing managers to focus on value-enhancing projects.

Question 34

Why is 'EPS increases with leverage' a fallacy for valuing a firm?

Answer 34

Because higher EPS does not imply higher value; increased risk also raises the required return on equity, leaving value unchanged.

Question 35

What is the fallacy behind 'issuing equity dilutes ownership'?

Answer 35

Although more shares are issued, if done at fair value, the ownership percentage changes but not the value per share, keeping shareholder value unchanged.