Module 9: Multiple Choice Questions

For students

Last updated: 24/10/2025 14:06

The questions are based on or inspired by the following references:

• Berk & DeMarzo, Corporate Finance, 5th ed. (2020)
  
• Brealey & Myers, Principles of Corporate Finance, 13th ed. (2020)

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💡 You can also press Ctrl + P (or Cmd + P on Mac) to print or save your responses as a .pdf file.

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⚠️ These exercises are powered by AI-assisted technologies and may contain occasional formatting or logic errors. Please report any issues you encounter so I can improve the experience.

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📘 Part 1 (until Midterm)

Module	Chapter	Slides	T/F	MCQ	Numeric	Long	Self-quiz
9	ch16	🎞️	✅	❓	🔢	📝	🧪

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Q1.

Which of the following best describes financial distress in a firm?

A. A temporary decline in the firm’s stock price.
B. A situation where a firm struggles to meet debt obligations or violates covenants.
C. Any reduction in firm profitability.
D. When the firm replaces debt with equity financing.
E. A loss of market share to competitors.

✅ B is correct. Financial distress occurs when a firm cannot fulfill its debt obligations or violates loan covenants.

Q2.

Which of the following is an example of an indirect cost of financial distress?

A. Legal fees paid during bankruptcy.
B. Auditor and consultant fees for restructuring.
C. Filing costs associated with Chapter 11 procedures.
D. The loss of key customers or suppliers due to uncertainty about the firm’s survival.
E. Administrative expenses in liquidation.

✅ D is correct. Indirect costs include reputation damage and lost business relationships during financial distress.

Q3.

According to the trade-off theory, what determines a firm’s optimal debt level?

A. The point where the present value of tax benefits equals the present value of financial distress and agency costs.
B. The firm’s ability to fully deduct interest expenses.
C. The lowest possible cost of equity financing.
D. The level of retained earnings available.
E. The industry average debt-to-equity ratio.

✅ A is correct. The trade-off theory states that firms balance tax benefits of debt with expected costs of distress and agency conflicts.

Q4.

What is the primary reason why shareholders may favor riskier projects when a firm is highly leveraged?

A. Risky projects increase the firm’s credit rating.
B. Risky projects increase the firm’s tax benefits.
C. Shareholders benefit from upside gains, while debtholders bear more downside risk.
D. Creditors prefer riskier investment portfolios.
E. Risky projects guarantee higher free cash flows.

✅ C is correct. This is the classic “asset substitution” problem—shareholders gain from upside volatility while debt absorbs losses.

Q5.

Which of the following best illustrates the debt overhang problem?

A. Managers investing in risky projects to benefit shareholders.
B. Firms issuing more debt to finance new projects.
C. Shareholders preferring higher dividend payouts.
D. Debtholders refusing to refinance maturing bonds.
E. Shareholders rejecting a positive-NPV project because most gains would go to creditors.

✅ E is correct. In debt overhang, equity holders avoid financing new profitable projects as the benefits mainly accrue to debtholders.

Q6.

Which of the following is an example of an agency benefit of leverage?

A. Increased flexibility in dividend policy.
B. Greater discretion for managers in investment decisions.
C. Reduction of the firm’s tax shield.
D. Reduction of wasteful spending by managers due to limited free cash flow.
E. Increased information asymmetry between managers and shareholders.

✅ D is correct. According to the free cash flow hypothesis, debt disciplines managers by reducing funds available for unproductive use.

Q7.

What does the signaling theory of debt suggest about firms with higher leverage?

A. They signal higher probability of default.
B. They signal poor investment opportunities.
C. They signal managerial confidence in future cash flows and profitability.
D. They signal inability to issue new equity.
E. They signal a decline in firm value.

✅ C is correct. Under asymmetric information, taking on more debt can signal that managers are confident in future performance.

Q8.

Which of the following is NOT an assumption of Modigliani and Miller Proposition I in a perfect market?

A. Financial distress and agency costs exist.
B. Investors can borrow and lend at the same rate as firms.
C. No taxes are present.
D. Securities are fairly priced.
E. Investment decisions are fixed and independent of financing.

✅ A is correct. MM assumes perfect markets with no taxes, no bankruptcy, and no agency costs.

Q9.

Which of the following statements best describes asymmetric information?

A. All investors have identical information about firm value.
B. Managers possess less information than shareholders.
C. Creditors have complete knowledge of all firm projects.
D. Stock prices are unaffected by information differences.
E. Managers have superior information about the firm’s future prospects compared to investors.

✅ E is correct. Asymmetric information occurs when managers know more about firm prospects than outside investors.

Q10.

According to the pecking order theory, firms prefer which sequence of financing sources?

A. Equity, debt, retained earnings.
B. Debt, equity, retained earnings.
C. Retained earnings, equity, debt.
D. Retained earnings, debt, equity.
E. Debt, retained earnings, equity.

✅ D is correct. Firms use internal funds first, then debt, and issue equity only as a last resort to minimize information costs.

Q11.

What is the main reason that financial distress is more costly for firms with intangible assets?

A. They can easily liquidate their assets for high resale value.
B. Their creditors can seize collateral more effectively.
C. Intangible assets lose most of their value during bankruptcy, reducing recovery for creditors.
D. Intangible assets attract fewer investors.
E. They face lower tax rates on asset write-downs.

✅ C is correct. Intangible assets such as brand value or R&D have little resale value, making distress more damaging.

Q12.

Why might high leverage discourage managers from taking positive-NPV projects?

A. Because most of the project’s benefits would go to debtholders, not shareholders.
B. Because leverage increases the cost of capital for all projects.
C. Because managers receive higher bonuses when leverage declines.
D. Because equity holders lose control in high-debt situations.
E. Because lenders demand dividends before new investment.

✅ A is correct. This is the debt-overhang effect—shareholders may reject positive-NPV projects when gains mainly benefit creditors.

Q13.

What is an agency cost of equity?

A. The cost of issuing new shares.
B. The interest paid on outstanding loans.
C. The decline in value due to reduced tax shields.
D. The loss of value from managers pursuing personal goals instead of maximizing shareholder wealth.
E. The transaction costs of paying dividends.

✅ D is correct. Agency costs of equity arise when managers act in their own interest rather than in shareholders’ best interests.

Q14.

Which of the following statements best describes debt covenants?

A. They are designed solely to increase firm leverage.
B. They restrict managerial actions that could harm creditors’ interests.
C. They allow managers to issue additional debt freely.
D. They eliminate all agency conflicts within the firm.
E. They guarantee a fixed interest rate over time.

✅ B is correct. Covenants align shareholder and creditor interests by preventing actions that increase default risk.

Q15.

Which of the following is a potential benefit of leverage?

A. Increased bankruptcy costs.
B. Higher free cash flow available to managers.
C. Reduced tax deductibility of interest.
D. Greater flexibility in capital budgeting.
E. Greater managerial discipline due to required interest payments.

✅ E is correct. Debt obligations force managers to generate cash flow and avoid wasteful spending, aligning incentives.

Q16.

Which of the following best explains the pecking-order theory of financing?

A. Firms always prefer to issue new equity first.
B. Firms prefer external debt to internal funds.
C. Firms prefer internal financing, then debt, and issue equity only as a last resort.
D. Firms choose capital structure to match competitors.
E. Firms maximize leverage to exploit tax benefits.

✅ C is correct. The pecking-order theory prioritizes funding that minimizes asymmetric information costs.

Q17.

What is the “free cash flow problem” in corporate finance?

A. Managers may use excess cash for unprofitable or self-serving projects.
B. Firms may fail to pay interest on time.
C. Shareholders prefer dividends to reinvestment.
D. Debt holders refuse to finance future projects.
E. Firms pay excessive taxes on retained earnings.

✅ A is correct. The free cash flow problem arises when managers overinvest or misuse excess funds rather than returning them to shareholders.

Q18.

What is the primary cause of asymmetric information between managers and investors?

A. Investors’ irrational behavior in financial markets.
B. Managers having better access to internal information about firm prospects.
C. The lack of credit ratings for private firms.
D. The use of off-balance-sheet financing.
E. Differences in accounting standards across countries.

✅ B is correct. Managers know more about firm operations and future performance than outside investors, leading to information asymmetry.

Q19.

Which of the following statements about financial distress is TRUE?

A. It always leads to bankruptcy.
B. It only affects firms with high tangible assets.
C. It never impacts a firm’s relationships with suppliers.
D. It increases firm value by reducing taxes.
E. It can reduce firm value by creating uncertainty for customers, suppliers, and employees.

✅ E is correct. Even without bankruptcy, financial distress can hurt relationships and damage long-term firm value.

Q20.

According to the trade-off theory, why don’t firms use 100% debt financing?

A. Debt is always more expensive than equity.
B. Taxes make debt unattractive to investors.
C. The expected costs of financial distress increase as leverage rises.
D. Shareholders cannot benefit from interest deductions.
E. Interest payments reduce free cash flow.

✅ C is correct. While debt provides tax benefits, excessive leverage raises the risk and cost of financial distress.

Q21.

Why might managers be reluctant to issue new equity according to signaling theory?

A. Because issuing equity always increases firm value.
B. Because investors may interpret it as a signal that the firm’s stock is overvalued.
C. Because equity issuance reduces control for creditors.
D. Because it decreases the firm’s cash reserves.
E. Because taxes on dividends increase after equity issuance.

✅ B is correct. Under asymmetric information, issuing new equity may signal to investors that management believes the firm is overvalued.

Q22.

What type of firm is most likely to suffer large indirect costs of financial distress?

A. Firms with stable cash flows and tangible assets.
B. Firms in regulated industries.
C. Firms with few customers and low leverage.
D. Firms with diversified operations and high liquidity.
E. Firms with valuable intangible assets and customer relationships.

✅ E is correct. Firms relying on reputation or intangible assets suffer more from lost confidence and relationship breakdowns.

Q23.

What happens when a firm violates a debt covenant?

A. The firm is automatically declared bankrupt.
B. The firm must issue new shares to creditors.
C. Creditors may demand immediate repayment or renegotiate loan terms.
D. The firm receives an automatic tax penalty.
E. The firm’s debt becomes non-interest bearing.

✅ C is correct. Covenant violations can trigger renegotiations, tighter restrictions, or acceleration of repayment.

Q24.

According to agency theory, why can leverage increase firm value?

A. Because debt reduces free cash flow available for managerial misuse.
B. Because managers can easily delay interest payments.
C. Because leverage increases investment flexibility.
D. Because debt eliminates financial distress costs.
E. Because it removes all conflicts between equity and debt holders.

✅ A is correct. Debt acts as a disciplinary mechanism, limiting excess cash that managers might otherwise waste.

Q25.

What is a typical indirect cost of financial distress?

A. Court filing fees for bankruptcy.
B. Payments to bankruptcy trustees.
C. Administrative fees for debt restructuring.
D. Lost sales due to customer doubts about the firm’s stability.
E. Audit and consulting fees.

✅ D is correct. Indirect costs include the loss of reputation, customer trust, and supplier confidence.

Q26.

Which of the following statements best describes the leverage ratchet effect?

A. Managers prefer to decrease leverage after profitability rises.
B. Shareholders resist reducing leverage even when it would increase firm value.
C. Firms always return to their optimal debt ratio after shocks.
D. Creditors demand more collateral after leverage increases.
E. The firm’s capital structure oscillates with market volatility.

✅ B is correct. Once debt is issued, shareholders are reluctant to reduce it, since deleveraging mainly benefits creditors.

Q27.

How does high leverage affect management incentives?

A. It encourages overinvestment in low-return projects.
B. It reduces focus on profitability.
C. It increases the likelihood of empire building.
D. It has no effect on managerial behavior.
E. It can align managerial actions with creditors and shareholders by imposing financial discipline.

✅ E is correct. Required debt payments create pressure on managers to operate efficiently and focus on value creation.

Q28.

What is the main insight from the pecking-order theory regarding equity issuance?

A. Issuing equity is a last resort because it signals potential overvaluation.
B. Firms issue equity before using retained earnings.
C. Equity issuance is always preferred to debt for tax reasons.
D. Managers and investors always agree on firm value.
E. Equity issuance lowers information asymmetry.

✅ A is correct. Firms avoid issuing equity unless necessary, as it may signal to investors that shares are overpriced.

Q29.

What is the main idea behind the trade-off theory of capital structure?

A. Firms always prefer internal financing to external financing.
B. There is a single optimal leverage level common to all firms.
C. Firms minimize taxes by maximizing debt indefinitely.
D. Firms balance tax benefits of debt against expected costs of financial distress and agency problems.
E. Firms choose leverage based only on market timing.

✅ D is correct. The trade-off theory predicts that optimal leverage occurs where marginal tax benefits equal marginal costs of debt.

Q30.

Which of the following factors increases the likelihood of financial distress?

A. Low operating leverage and stable cash flows.
B. A high proportion of tangible assets.
C. High business risk and volatile cash flows.
D. Low fixed-cost structure.
E. High diversification across industries.

✅ C is correct. Firms with volatile earnings face a higher probability of financial distress due to inconsistent cash flows.

Q31.

Which of the following best explains why debt can act as a disciplinary mechanism?

A. Because debt forces managers to make interest payments, reducing the temptation to waste free cash flow.
B. Because debt increases firm liquidity.
C. Because creditors share control of the firm with managers.
D. Because debt guarantees higher profitability.
E. Because debt reduces firm value volatility.

✅ A is correct. Debt commitments limit managerial discretion and encourage efficiency through required cash payments.

Q32.

What is the primary purpose of restrictive debt covenants?

A. To allow managers greater flexibility in investment decisions.
B. To reduce firm risk by eliminating all debt.
C. To maximize tax benefits of interest payments.
D. To prevent actions that could transfer wealth from creditors to shareholders.
E. To allow creditors to manage the firm directly.

✅ D is correct. Debt covenants protect creditors by restricting risky activities that might harm their interests.

Q33.

According to the pecking-order theory, why do firms prefer internal financing?

A. Because internal funds provide tax advantages.
B. Because internal funds increase the cost of equity.
C. Because using internal funds avoids information asymmetry and issuance costs.
D. Because retained earnings reduce the need for working capital.
E. Because managers can hide negative performance when using internal funds.

✅ C is correct. Internal financing avoids negative market signals and the costs of external financing.

Q34.

Which of the following statements about agency conflicts is TRUE?

A. They only exist between shareholders and managers.
B. They are eliminated when firms issue debt.
C. They are not relevant to capital structure decisions.
D. They disappear when firms reach their optimal leverage.
E. They can arise both between shareholders and managers, and between shareholders and creditors.

✅ E is correct. Agency conflicts occur in multiple relationships—between owners, managers, and debtholders.

Q35.

Which of the following is an example of an indirect financial distress cost?

A. Legal and accounting fees in bankruptcy.
B. The loss of customer trust leading to a fall in sales.
C. Administrative court costs.
D. Restructuring advisor fees.
E. Consulting expenses for auditing new projects.

✅ B is correct. Lost reputation and business relationships are typical indirect costs of financial distress.

Q36.

According to the free cash flow hypothesis, how does debt mitigate agency problems?

A. By allowing managers to invest freely in new projects.
B. By increasing the firm’s financial slack.
C. By reducing the need for external financing.
D. By forcing managers to use free cash flow for interest payments instead of wasteful spending.
E. By eliminating information asymmetry between investors and managers.

✅ D is correct. Debt reduces discretionary funds and aligns managerial incentives with firm value creation.

Q37.

Which of the following describes an overinvestment problem?

A. Managers reject positive-NPV projects to preserve cash.
B. Shareholders refuse to fund projects that benefit debtholders.
C. Managers pursue negative-NPV projects for personal benefits or empire building.
D. Managers pay out all free cash flow as dividends.
E. Investors overvalue equity issues in the short term.

✅ C is correct. Overinvestment occurs when managers invest in unprofitable projects that increase their control or prestige.

Q38.

Why do firms with volatile earnings often choose lower leverage?

A. Because unstable cash flows raise the risk of financial distress.
B. Because debt becomes cheaper when volatility increases.
C. Because volatility increases the firm’s tax benefits.
D. Because high volatility eliminates bankruptcy costs.
E. Because lenders prefer riskier borrowers.

✅ A is correct. Firms with unstable earnings prefer less debt to reduce the probability and cost of distress.

Q39.

Which of the following statements about asymmetric information is TRUE?

A. It leads investors to overestimate firm value during equity issuance.
B. It can cause managers to prefer debt financing to avoid negative market reactions to equity issuance.
C. It does not influence the firm’s financing decisions.
D. It benefits uninformed investors.
E. It reduces adverse selection problems.

✅ B is correct. Managers may prefer debt to avoid sending a negative signal to investors about potential overvaluation.

Q40.

Which of the following statements best summarizes the trade-off theory?

A. Firms use only internal funds to avoid taxes.
B. Firms increase leverage until interest coverage becomes negative.
C. Firms aim to minimize both debt and equity simultaneously.
D. Firms ignore bankruptcy costs when choosing leverage.
E. Firms choose leverage to balance tax shields against expected costs of financial distress and agency problems.

✅ E is correct. The trade-off theory explains that optimal capital structure balances tax advantages with the risks and costs of debt.

Q41.

Which of the following best describes the underinvestment problem?

A. Managers investing too much in low-return projects.
B. Shareholders refusing to pay dividends to creditors.
C. Shareholders rejecting positive-NPV projects because benefits primarily accrue to debt holders.
D. Creditors refusing to lend to profitable firms.
E. Managers overestimating project NPV to justify leverage.

✅ C is correct. The underinvestment problem occurs when shareholders avoid new investment since returns mainly benefit debtholders.

Q42.

Why can debt reduce managerial entrenchment?

A. Because debt provides more voting power to managers.
B. Because creditors share managerial bonuses.
C. Because debt eliminates free cash flow volatility.
D. Because interest payments are tax deductible.
E. Because fixed debt obligations force managers to operate efficiently to meet payments.

✅ E is correct. Debt pressures managers to perform efficiently, reducing the scope for entrenchment and wasteful behavior.

Q43.

Which statement is consistent with the signaling role of leverage?

A. Firms increase leverage only when they expect future losses.
B. Firms with higher expected cash flows choose more debt to signal confidence in their prospects.
C. Firms with higher leverage are viewed as riskier and less valuable.
D. Leverage has no informational content for investors.
E. Firms avoid leverage to signal future stability.

✅ B is correct. High leverage can signal managerial confidence about strong future cash flows.

Q44.

Which of the following is a direct cost of financial distress?

A. Legal and administrative costs of bankruptcy proceedings.
B. Decline in employee productivity due to uncertainty.
C. Loss of customer relationships.
D. Drop in supplier confidence.
E. Reputational damage in the market.

✅ A is correct. Direct costs are explicit expenses incurred during legal or administrative processes in distress.

Q45.

Which of the following best describes the debt-overhang problem?

A. Managers borrow excessively to fund negative-NPV projects.
B. Firms issue equity to avoid financial distress.
C. Shareholders avoid financing new profitable projects since benefits mainly accrue to debt holders.
D. Debtholders refuse to refinance a profitable firm.
E. Firms are unable to deduct interest from taxes.

✅ C is correct. Debt overhang discourages equity holders from investing in positive-NPV projects that primarily benefit creditors.

Q46.

Which of the following firms is most likely to use higher leverage?

A. A biotech startup with uncertain revenues.
B. A software firm with high R&D intensity.
C. A luxury brand relying heavily on reputation.
D. A manufacturing company with stable cash flows and tangible assets.
E. A high-growth tech firm with negative earnings.

✅ D is correct. Firms with stable cash flows and tangible assets face lower distress costs and can sustain higher leverage.

Q47.

Which of the following statements about the pecking-order theory is TRUE?

A. Firms prefer to issue equity before debt.
B. Firms use internal funds first, then debt, and issue equity only when necessary.
C. The theory predicts an optimal capital structure for each firm.
D. It assumes markets are perfectly efficient.
E. It states that equity issuance always increases firm value.

✅ B is correct. The pecking-order theory reflects financing hierarchy based on information asymmetry and cost of capital.

Q48.

What is the relationship between profitability and leverage under the pecking-order theory?

A. More profitable firms always issue new equity.
B. Profitability and leverage are unrelated.
C. More profitable firms tend to use more debt to benefit from tax shields.
D. Profitability leads firms to maintain a target debt ratio.
E. More profitable firms tend to use less debt because they rely on internal funds.

✅ E is correct. Profitable firms often have sufficient internal funds and thus rely less on external debt financing.

Q49.

Which statement about financial distress is CORRECT?

A. It has no effect on a firm’s operations.
B. It always results in liquidation.
C. It can destroy firm value even without bankruptcy through lost reputation and relationships.
D. It always increases shareholder wealth.
E. It guarantees lower taxes for the firm.

✅ C is correct. Financial distress damages reputation and stakeholder trust even if bankruptcy is avoided.

Q50.

According to the trade-off theory, what happens when a firm increases its leverage beyond the optimal point?

A. The marginal cost of financial distress exceeds the marginal tax benefit of debt.
B. The firm’s WACC continues to decline.
C. The firm eliminates agency conflicts.
D. Shareholders’ required return decreases.
E. The firm becomes risk-free.

✅ A is correct. Beyond the optimal leverage level, additional debt destroys value as distress costs outweigh tax benefits.

Q51.

According to the trade-off theory, what happens when a firm increases its leverage beyond the optimal point?

A. The marginal cost of financial distress exceeds the marginal tax benefit of debt.
B. The firm’s WACC continues to decline.
C. The firm eliminates agency conflicts.
D. Shareholders’ required return decreases.
E. The firm becomes risk-free.

✅ A is correct. Beyond the optimal leverage level, additional debt destroys value as distress costs outweigh tax benefits.

Q52.

Which of the following is a potential benefit of financial leverage?

A. It increases the probability of bankruptcy.
B. It reduces managerial accountability.
C. It lowers expected returns to equity.
D. It increases agency costs of debt.
E. It disciplines managers by committing future cash flows to debt service.

✅ E is correct. Debt obligations can discipline managers, encouraging efficient use of cash and avoidance of wasteful projects.

Q53.

According to the trade-off theory, when is it optimal for a firm to issue additional debt?

A. When tax rates decrease.
B. When the marginal tax benefit of debt exceeds the marginal expected cost of distress.
C. When the cost of debt rises sharply.
D. When profits are volatile.
E. When agency costs dominate tax benefits.

✅ B is correct. Firms add debt until tax benefits are offset by the rising expected cost of financial distress.

Q54.

Which of the following firms is least likely to use high leverage?

A. A utility company with stable cash flows.
B. A real estate firm with tangible assets.
C. A manufacturer with predictable sales.
D. A biotechnology startup with uncertain future earnings.
E. A large industrial firm with stable demand.

✅ D is correct. Startups with uncertain revenues face high financial distress risk and thus avoid excessive debt.

Q55.

Why might leverage create conflicts between shareholders and creditors?

A. Because shareholders might undertake riskier projects to benefit themselves at creditors’ expense.
B. Because creditors always share project profits.
C. Because leverage decreases shareholder returns.
D. Because higher leverage eliminates bankruptcy costs.
E. Because interest payments reduce firm risk.

✅ A is correct. This is the asset substitution problem—shareholders may favor riskier investments once debt is in place.

Q56.

Which of the following is an example of managerial entrenchment?

A. Managers increasing leverage to improve efficiency.
B. Managers focusing on maximizing shareholder value.
C. Managers increasing dividends to build investor trust.
D. Managers aligning bonuses with long-term performance.
E. Managers resisting takeover bids to protect their positions.

✅ E is correct. Entrenched managers act to preserve control even when takeovers could increase shareholder value.

Q57.

According to signaling theory, what does a firm’s decision to increase debt typically indicate?

A. Management expects declining future cash flows.
B. Management wants to reduce firm value.
C. Management has inside information that the firm is overvalued.
D. Management is confident about future earnings and cash flow stability.
E. Management anticipates a future tax increase.

✅ D is correct. Taking on more debt signals confidence in future cash flows since managers commit to fixed obligations.

Q58.

Which of the following can be considered an indirect cost of financial distress?

A. Legal fees during bankruptcy.
B. Auditor and consultant payments.
C. Loss of customers and suppliers due to reduced confidence.
D. Tax penalties for defaulting on payments.
E. Filing costs for liquidation.

✅ C is correct. Indirect costs arise when distress weakens reputation, leading to sales losses and strained relationships.

Q59.

How can equity issuance create an adverse selection problem?

A. Investors always overprice new shares.
B. Investors may assume managers issue equity when shares are overvalued.
C. Managers lose control over investment policy.
D. Equity issuance eliminates tax advantages.
E. It reduces transparency in the market.

✅ B is correct. Under asymmetric information, investors interpret new equity as a signal that shares may be overpriced.

Q60.

Why are firms with high intangible assets often less leveraged?

A. Because they have no use for tax shields.
B. Because intangible assets increase collateral value.
C. Because creditors prefer intangible assets for security.
D. Because intangible assets reduce bankruptcy probability.
E. Because intangible assets are difficult to use as collateral, raising potential distress costs.

✅ E is correct. Intangible-heavy firms face higher expected distress costs since such assets lose value in bankruptcy.

Q61.

Which of the following best explains why debt holders impose covenants on borrowers?

A. To increase firm profitability.
B. To allow managers more flexibility in investment.
C. To prevent managers from taking actions that increase risk at creditors’ expense.
D. To reduce the firm’s tax burden.
E. To ensure higher dividend payments.

✅ C is correct. Covenants restrict risky managerial behavior and protect creditors from value-reducing actions.

Q62.

How does leverage affect the incentives of equity holders in distress?

A. It can lead them to favor riskier projects since losses are shared with debt holders.
B. It makes shareholders more conservative in investment choices.
C. It eliminates the need for risk-taking incentives.
D. It discourages any investment decisions.
E. It aligns shareholder and creditor interests completely.

✅ A is correct. When firms are highly leveraged, shareholders may prefer riskier projects due to limited downside exposure.

Q63.

Which of the following is an implication of the free cash flow hypothesis?

A. Managers always maximize shareholder value.
B. Firms with more free cash flow have fewer agency problems.
C. Increasing debt reduces firm value by limiting flexibility.
D. Debt can improve efficiency by reducing excess cash available for wasteful spending.
E. Managers prefer to hold excess cash for shareholder payouts.

✅ D is correct. Debt commitments force managers to use free cash efficiently, lowering agency costs.

Q64.

What does the pecking-order theory suggest about firms with large cash reserves?

A. They will issue equity more frequently.
B. They will increase leverage aggressively.
C. They will rely heavily on short-term debt.
D. They face higher information asymmetry.
E. They will prefer to finance projects internally rather than issue debt or equity.

✅ E is correct. Firms with sufficient cash prefer internal financing to avoid signaling problems or issuance costs.

Q65.

Which statement best describes the trade-off theory of capital structure?

A. Firms always prefer equity to debt.
B. Firms balance the tax benefits of debt with expected financial distress costs.
C. Firms ignore taxes when choosing capital structure.
D. Firms minimize the cost of equity to determine leverage.
E. Firms target a 50-50 split between debt and equity.

✅ B is correct. The trade-off theory suggests firms weigh tax advantages of debt against bankruptcy and agency costs.

Q66.

What is a common outcome of information asymmetry in financial markets?

A. Firms always issue new equity.
B. Investors have perfect information about firm quality.
C. Investors may undervalue equity issues, leading firms to prefer debt or internal financing.
D. Managers lose control over financing decisions.
E. Firms experience lower cost of capital.

✅ C is correct. Asymmetric information often leads to undervaluation of equity, reinforcing the preference for debt or retained earnings.

Q67.

Which factor increases the likelihood of high financial distress costs?

A. High business risk and volatile cash flows.
B. Large proportions of tangible assets.
C. Stable operating margins.
D. Conservative dividend policies.
E. Low debt ratios.

✅ A is correct. Firms with volatile earnings face higher probability and cost of financial distress.

Q68.

What does the debt-overhang problem imply?

A. Firms with too much debt have more investment flexibility.
B. High leverage increases the attractiveness of new projects.
C. Shareholders benefit from all project returns.
D. Debtholders finance all positive-NPV projects.
E. High leverage discourages shareholders from funding new positive-NPV projects.

✅ E is correct. Debt overhang leads shareholders to reject profitable projects when benefits mainly accrue to debtholders.

Q69.

Which of the following is a consequence of high leverage for equity holders?

A. Reduced volatility of returns.
B. Higher required return due to increased risk.
C. Guaranteed dividend payments.
D. Lower probability of default.
E. Greater control by creditors over firm policy.

✅ B is correct. Increased leverage raises equity risk, leading to higher expected returns required by shareholders.

Q70.

Which of the following is a managerial action consistent with the agency cost of equity?

A. Managers using debt to discipline themselves.
B. Managers issuing equity to fund high-return projects.
C. Managers investing in projects that increase firm size but not value.
D. Managers distributing all cash as dividends.
E. Managers reducing leverage to avoid default.

✅ C is correct. Overinvestment in unprofitable expansion reflects agency costs when managers prioritize personal objectives.

Q71.

A firm has a 25% probability of entering financial distress. If distress leads to a loss of $60 million in firm value, what is the expected cost of financial distress?

A. $10 million
B. $12 million
C. $15 million
D. $20 million
E. $25 million

✅ C is correct. Expected distress cost = 0.25 × 60 = $15 million.

Q72.

An unlevered firm is worth 500 million. Adding debt creates a tax benefit of 40 million but expected financial distress costs of 10 million. What is the levered value of the firm?

A. $490 million
B. $510 million
C. $520 million
D. $530 million
E. $540 million

✅ D is correct. Levered value = 500 + 40 − 10 = $530 million.

Q73.

If a firm’s unlevered value is 800 million, the present value of tax shields is 60 million, and the expected cost of distress is 20 million, what is the value of the levered firm?

A. $780 million
B. $800 million
C. $840 million
D. $860 million
E. $900 million

✅ C is correct. V_L = V_U + PV(Tax Shield) − PV(Distress Cost) = 800 + 60 − 20 = 840.

Q74.

A firm plans to issue $150 million of 10-year debt at 8% interest. The tax rate is 25%, and the discount rate for the tax shield is 8%. What is the present value of the tax shields over the debt’s life?

A. $25 million
B. $28.1 million
C. $32 million
D. $36 million
E. $40 million

✅ Correct: B.
Annual shield = 150 × 0.08 × 0.25 = 3.0 million.
PV = 3.0 × [1 − (1 / 1.08¹⁰)] / 0.08 = $28.1 million.

Q75.

A firm’s probability of bankruptcy is 15%, and the estimated cost in bankruptcy is $120 million. What is the expected cost of distress?

A. $5 million
B. $9 million
C. $12 million
D. $18 million
E. $25 million

✅ D is correct. Expected cost = 0.15 × 120 = $18 million.

Q76.

If a firm’s debt provides a tax benefit of 5 million per year and the expected cost of distress is 1 million, what is the net benefit of leverage?

A. $4 million loss
B. $4 million gain
C. $6 million gain
D. $5 million loss
E. Zero

✅ B is correct. Net effect = Tax benefit − Expected distress cost = 5 − 1 = $4 million.

Q77.

A firm’s value without leverage is 500 million. Debt adds 50 million in tax benefits but 10 million in expected distress costs. What is the firm’s value with leverage?

A. $510 million
B. $520 million
C. $530 million
D. $540 million
E. $540 million

✅ E is correct. Levered value = Unlevered + Tax benefits − Distress cost = 500 + 50 − 10 = 540.

Q78.

A firm has an unlevered value of 900 million. It expects to gain 60 million in tax shields from debt but lose 20 million to agency and distress costs. What is the value of the levered firm?

A. $900 million
B. $920 million
C. $940 million
D. $950 million
E. $940 million

✅ E is correct. Value = 900 + 60 − 20 = $940 million.

Q79.

A firm’s managers may waste 4% of firm value through poor investment decisions when leverage is low. If the firm is worth $500 million, what is the expected agency cost in dollars?

A. $10 million
B. $20 million
C. $25 million
D. $15 million
E. $30 million

✅ B is correct. Agency loss = 0.04 × 500 = $20 million.

Q80.

A firm’s debt generates a tax benefit of 30 million, while expected distress costs are 40 million. What is the net effect of leverage on firm value?

A. +$10 million
B. −$10 million
C. −$30 million
D. +$40 million
E. No change

✅ B is correct. The negative net effect (−10) means distress costs outweigh the tax advantage of debt.

Q81.

A firm owes 1 million to creditors. Its current assets are worth 900,000. A risky strategy offers a 50% chance of increasing asset value to 1.3 million or falling to 300,000. What is the expected firm value under the risky strategy?

A. $800,000
B. $850,000
C. $800,000
D. $900,000
E. $1,000,000

✅ C is correct. Expected value = 0.5×1.3m + 0.5×0.3m = $0.8m. The strategy reduces firm value but may still benefit equity holders.

Q82.

In the same scenario as before, what is the expected payoff to debt holders under the risky strategy (debt = $1 million)?

A. $700,000
B. $650,000
C. $600,000
D. $800,000
E. $1,000,000

✅ B is correct. Expected debt payoff = 0.5×1,000,000 + 0.5×300,000 = $650,000.

Q83.

Using the same data, what is the expected payoff to equity holders if the risky strategy is chosen?

A. $150,000
B. $100,000
C. $200,000
D. $250,000
E. $0

✅ A is correct. If success: equity = 1.3 − 1.0 = 0.3m; if failure: 0; expected = 0.5×0.3 = $150,000.

Q84.

A firm has face-value debt of 1,000,000 due at year-end. Without new investment, its assets will be worth 900,000. A project requires an equity-funded investment of 100,000 now and produces a certain payoff of 150,000 at year-end. If equity holders finance the project, how much of the project’s gain accrues to debt holders?

A. $20,000
B. $30,000
C. $40,000
D. $100,000
E. $150,000

✅ D is correct. Without the project, creditors get 900k (short of 1m). With the project, firm value is 900k + 150k = 1,050k, so creditors get their full 1m. The increase in creditor payoff is 100k — exactly the first 100k of the project’s gain.

Q85.

Using the same scenario: debt due = 1,000,000; assets without the project = 900,000; the project requires 100,000 from equity and pays 150,000 for sure. What is the project’s NPV from the shareholders’ perspective (ignoring discounting)?

A. +$50,000
B. −$50,000
C. +$100,000
D. $0
E. −$100,000

✅ B is correct. Equity invests 100k. With the project, equity receives 1,050k − 1,000k = 50k (vs. 0 without). So NPV to shareholders = 50k − 100k = −50k → classic debt overhang.

Q86.

A firm’s unlevered value is 600 million. With 200 million of debt, the PV of tax shields is 30 million, and PV of distress costs is 10 million. What is the levered value of the firm?

A. $610 million
B. $620 million
C. $620 million
D. $630 million
E. $640 million

✅ C is correct. Levered value = 600 + 30 − 10 = $620 million.

Q87.

If the PV of tax shields is 50 million and the PV of distress and agency costs together equals 50 million, what is the net benefit of leverage?

A. $0
B. $25 million
C. $10 million
D. $5 million
E. $100 million

✅ A is correct. When tax benefits equal total costs, the optimal leverage is reached—net gain is zero.

Q88.

A firm expects a tax shield benefit of 20 million if it borrows more, but also expects additional distress costs of 25 million. What is the effect on firm value if it increases debt?

A. +$45 million
B. +$5 million
C. No change
D. −$5 million
E. −$25 million

✅ D is correct. Added distress cost outweighs tax benefit → net effect = −5 million.

Q89.

A firm estimates that if bankruptcy occurs next year, it will incur legal and administrative costs of $20 million. The probability of bankruptcy is 30%, and the discount rate is 10%. What is the expected present value of bankruptcy costs?

A. $4.5 million
B. $5.0 million
C. $5.45 million
D. $6.0 million
E. $7.0 million

✅ C is correct. Expected cost = 0.3 × 20 = 6; discounted one year at 10% → 6 / 1.10 = $5.45 million.
This is the PV of expected bankruptcy losses considered in trade-off theory.

Q90.

A firm’s unlevered value is 500 million. The present value of tax shields increases by 10 million for each additional 100 million of debt. However, expected distress costs increase quadratically, adding 2 million, 8 million, and 18 million for the first three 100 million increments of debt, respectively. At what level of debt is firm value maximized?

A. $100 million
B. $200 million
C. $300 million
D. $200 million
E. $0

✅ D is correct.
Net gain by level of debt:
- 100m → +10 − 2 = +8
- 200m → +20 − 8 = +12
- 300m → +30 − 18 = +12
Value peaks at $200m debt (first point of maximum gain). Beyond that, costs rise faster than benefits.

Q91.

A firm has a 60% chance of remaining healthy with value 600 million, a 30% chance of moderate distress losing 40 million, and a 10% chance of bankruptcy losing 150 million. What is the expected firm value?

A. $540 million
B. $550 million
C. $556 million
D. $560 million
E. $580 million

✅ C is correct.
Expected value = 0.6×600 + 0.3×(600−40) + 0.1×(600−150) = 556 million.

Q92.

A firm’s base value is 400 million. If distress occurs (probability 20%), expected losses are 60 million. What is the expected cost of financial distress as a percentage of firm value?

A. 10%
B. 3%
C. 6%
D. 12%
E. 20%

✅ B is correct. Expected cost = 0.2×60 = 12; 12 / 400 = 3%.

Q93.

A firm’s interest tax shield is worth 30 million. The probability of distress is 25%, and the expected cost of distress is 100 million. What is the net effect of leverage on firm value?

A. +$5 million
B. +$10 million
C. −$5 million
D. 0
E. +$25 million

✅ A is correct. Expected distress cost = 0.25×100 = 25 → Net = 30 − 25 = +5 million.

Q94.

A company expects a tax benefit of 40 million from higher leverage. However, the probability of financial distress is 15% with expected costs of 300 million. What is the expected net impact on firm value?

A. +$5 million
B. +$10 million
C. −$5 million
D. −$5 million
E. −$10 million

✅ D is correct. Expected cost = 0.15×300 = 45 → Net impact = 40 − 45 = −5 million.

Q95.

A firm generates $60 million in free cash flow per year. Managers waste 8% of it on unproductive expenses. If new debt commitments force them to pay out 75% of cash flow to investors, what value is preserved?

A. $2 million
B. $3 million
C. $3.6 million
D. $4.8 million
E. $6 million

✅ C is correct. Value saved = 60×0.08×0.75 = 3.6 million. Debt can discipline managers by reducing waste.

Q96.

A corporate bond has a face value of $1,000 and a 10% probability of default. In default, investors recover only 60% of the face value. What is the expected value of the bond, ignoring discounting?

A. $920
B. $930
C. $960
D. $970
E. $990

✅ C is correct.
Expected payoff = 0.9×1,000 + 0.1×600 = 900 + 60 = $960.
This reflects the expected market value of risky debt before discounting.

Q97.

Investors believe there is a 50% chance a firm is high-quality (worth 100/share) and 50% chance low-quality (70/share). The firm announces an equity issue, which only low-quality firms choose. What will be the new market price per share?

A. $70
B. $80
C. $85
D. $90
E. $100

✅ A is correct.
If only low-quality firms issue, the market updates beliefs → price = $70, the value of low-type shares.

Q98.

A firm can issue either debt or equity. High-quality firms (value 120) choose debt, while low-quality ones (value 80) choose equity. If investors observe a debt issue, what is the implied expected firm value?

A. $80
B. $90
C. $100
D. $120
E. $110

✅ D is correct.
Choosing debt signals confidence → market infers firm is high-type (value $120).

Q99.

A firm owes 80 million in debt and currently holds safe assets worth 75 million. A risky project can increase total assets to 120 million with 50% chance or reduce them to 50 million with 50% chance. What is the expected loss to debt holders if shareholders choose the risky project?

A. $5 million
B. $10 million
C. $15 million
D. $20 million
E. $25 million

✅ B is correct.
Expected debt payoff = 0.5×80 + 0.5×50 = 65 → vs. 75 from safe assets → loss = 10.

Q100.

After several years of high borrowing, a firm’s management considers repurchasing 100 million of outstanding debt to reduce leverage. Financial analysts estimate that this action would increase total firm value by 15 million because it lowers expected distress costs. However, it would also transfer 20 million of value from shareholders to debt holders, since creditors would gain from the safer balance sheet. According to the leverage ratchet effect, what is the likely decision by shareholders?

A. Reject the repurchase and keep high leverage
B. Repurchase the debt to maximize total firm value
C. Issue new equity to finance the repurchase
D. Convert part of debt into equity
E. Defer the decision until debt matures

✅ A is correct.
Even though the firm’s total value would rise by 15 million, shareholders personally lose $5 million due to the value transfer to creditors.
They will therefore oppose deleveraging — a key implication of the leverage ratchet effect, where equity holders resist reducing leverage even when it increases firm value.

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