Module 9: Multiple Choice Questions
Last updated: 08/01/2026 17:52
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)
💡 You can also press Ctrl + P (or Cmd + P on Mac) to print or save your responses as a .pdf file.
⚠️ 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.
📙 Part 2 (Midterm to Final)
| Module | Chapter |
|---|---|
| 9 | ch16 |
Select the correct answers.
✅ B is correct. Financial distress occurs when a firm cannot fulfill its debt obligations or violates loan covenants.
✅ D is correct. Indirect costs include reputation damage and lost business relationships during financial distress.
✅ A is correct. The trade-off theory states that firms balance tax benefits of debt with expected costs of distress and agency conflicts.
✅ C is correct. This is the classic “asset substitution” problem—shareholders gain from upside volatility while debt absorbs losses.
✅ E is correct. In debt overhang, equity holders avoid financing new profitable projects as the benefits mainly accrue to debtholders.
✅ D is correct. According to the free cash flow hypothesis, debt disciplines managers by reducing funds available for unproductive use.
✅ C is correct. Under asymmetric information, taking on more debt can signal that managers are confident in future performance.
✅ A is correct. MM assumes perfect markets with no taxes, no bankruptcy, and no agency costs.
✅ E is correct. Asymmetric information occurs when managers know more about firm prospects than outside investors.
✅ D is correct. Firms use internal funds first, then debt, and issue equity only as a last resort to minimize information costs.
✅ C is correct. Intangible assets such as brand value or R&D have little resale value, making distress more damaging.
✅ A is correct. This is the debt-overhang effect—shareholders may reject positive-NPV projects when gains mainly benefit creditors.
✅ D is correct. Agency costs of equity arise when managers act in their own interest rather than in shareholders’ best interests.
✅ B is correct. Covenants align shareholder and creditor interests by preventing actions that increase default risk.
✅ E is correct. Debt obligations force managers to generate cash flow and avoid wasteful spending, aligning incentives.
✅ C is correct. The pecking-order theory prioritizes funding that minimizes asymmetric information costs.
✅ A is correct. The free cash flow problem arises when managers overinvest or misuse excess funds rather than returning them to shareholders.
✅ B is correct. Managers know more about firm operations and future performance than outside investors, leading to information asymmetry.
✅ E is correct. Even without bankruptcy, financial distress can hurt relationships and damage long-term firm value.
✅ C is correct. While debt provides tax benefits, excessive leverage raises the risk and cost of financial distress.
✅ B is correct. Under asymmetric information, issuing new equity may signal to investors that management believes the firm is overvalued.
✅ E is correct. Firms relying on reputation or intangible assets suffer more from lost confidence and relationship breakdowns.
✅ C is correct. Covenant violations can trigger renegotiations, tighter restrictions, or acceleration of repayment.
✅ A is correct. Debt acts as a disciplinary mechanism, limiting excess cash that managers might otherwise waste.
✅ D is correct. Indirect costs include the loss of reputation, customer trust, and supplier confidence.
✅ B is correct. Once debt is issued, shareholders are reluctant to reduce it, since deleveraging mainly benefits creditors.
✅ E is correct. Required debt payments create pressure on managers to operate efficiently and focus on value creation.
✅ A is correct. Firms avoid issuing equity unless necessary, as it may signal to investors that shares are overpriced.
✅ D is correct. The trade-off theory predicts that optimal leverage occurs where marginal tax benefits equal marginal costs of debt.
✅ C is correct. Firms with volatile earnings face a higher probability of financial distress due to inconsistent cash flows.
✅ A is correct. Debt commitments limit managerial discretion and encourage efficiency through required cash payments.
✅ D is correct. Debt covenants protect creditors by restricting risky activities that might harm their interests.
✅ C is correct. Internal financing avoids negative market signals and the costs of external financing.
✅ E is correct. Agency conflicts occur in multiple relationships—between owners, managers, and debtholders.
✅ B is correct. Lost reputation and business relationships are typical indirect costs of financial distress.
✅ D is correct. Debt reduces discretionary funds and aligns managerial incentives with firm value creation.
✅ C is correct. Overinvestment occurs when managers invest in unprofitable projects that increase their control or prestige.
✅ A is correct. Firms with unstable earnings prefer less debt to reduce the probability and cost of distress.
✅ B is correct. Managers may prefer debt to avoid sending a negative signal to investors about potential overvaluation.
✅ E is correct. The trade-off theory explains that optimal capital structure balances tax advantages with the risks and costs of debt.
✅ C is correct. The underinvestment problem occurs when shareholders avoid new investment since returns mainly benefit debtholders.
✅ E is correct. Debt pressures managers to perform efficiently, reducing the scope for entrenchment and wasteful behavior.
✅ B is correct. High leverage can signal managerial confidence about strong future cash flows.
✅ A is correct. Direct costs are explicit expenses incurred during legal or administrative processes in distress.
✅ C is correct. Debt overhang discourages equity holders from investing in positive-NPV projects that primarily benefit creditors.
✅ D is correct. Firms with stable cash flows and tangible assets face lower distress costs and can sustain higher leverage.
✅ B is correct. The pecking-order theory reflects financing hierarchy based on information asymmetry and cost of capital.
✅ E is correct. Profitable firms often have sufficient internal funds and thus rely less on external debt financing.
✅ C is correct. Financial distress damages reputation and stakeholder trust even if bankruptcy is avoided.
✅ A is correct. Beyond the optimal leverage level, additional debt destroys value as distress costs outweigh tax benefits.
✅ A is correct. Beyond the optimal leverage level, additional debt destroys value as distress costs outweigh tax benefits.
✅ E is correct. Debt obligations can discipline managers, encouraging efficient use of cash and avoidance of wasteful projects.
✅ B is correct. Firms add debt until tax benefits are offset by the rising expected cost of financial distress.
✅ D is correct. Startups with uncertain revenues face high financial distress risk and thus avoid excessive debt.
✅ A is correct. This is the asset substitution problem—shareholders may favor riskier investments once debt is in place.
✅ E is correct. Entrenched managers act to preserve control even when takeovers could increase shareholder value.
✅ D is correct. Taking on more debt signals confidence in future cash flows since managers commit to fixed obligations.
✅ C is correct. Indirect costs arise when distress weakens reputation, leading to sales losses and strained relationships.
✅ B is correct. Under asymmetric information, investors interpret new equity as a signal that shares may be overpriced.
✅ E is correct. Intangible-heavy firms face higher expected distress costs since such assets lose value in bankruptcy.
✅ C is correct. Covenants restrict risky managerial behavior and protect creditors from value-reducing actions.
✅ A is correct. When firms are highly leveraged, shareholders may prefer riskier projects due to limited downside exposure.
✅ D is correct. Debt commitments force managers to use free cash efficiently, lowering agency costs.
✅ E is correct. Firms with sufficient cash prefer internal financing to avoid signaling problems or issuance costs.
✅ B is correct. The trade-off theory suggests firms weigh tax advantages of debt against bankruptcy and agency costs.
✅ C is correct. Asymmetric information often leads to undervaluation of equity, reinforcing the preference for debt or retained earnings.
✅ A is correct. Firms with volatile earnings face higher probability and cost of financial distress.
✅ E is correct. Debt overhang leads shareholders to reject profitable projects when benefits mainly accrue to debtholders.
✅ B is correct. Increased leverage raises equity risk, leading to higher expected returns required by shareholders.
✅ C is correct. Overinvestment in unprofitable expansion reflects agency costs when managers prioritize personal objectives.
✅ C is correct. Expected distress cost = 0.25 × 60 = $15 million.
✅ D is correct. Levered value = 500 + 40 − 10 = $530 million.
✅ C is correct. VL = VU + PV(Tax Shield) − PV(Distress Cost) = 800 + 60 − 20 = 840.
✅ Correct: B.
Annual shield = 150 × 0.08 × 0.25 = 3.0 million.
PV = 3.0 × [1 − (1 / 1.08¹⁰)] / 0.08 = $28.1 million.
✅ D is correct. Expected cost = 0.15 × 120 = $18 million.
✅ B is correct. Net effect = Tax benefit − Expected distress cost = 5 − 1 = $4 million.
✅ E is correct. Levered value = Unlevered + Tax benefits − Distress cost = 500 + 50 − 10 = 540.
✅ E is correct. Value = 900 + 60 − 20 = $940 million.
✅ B is correct. Agency loss = 0.04 × 500 = $20 million.
✅ B is correct. The negative net effect (−10) means distress costs outweigh the tax advantage of debt.
✅ 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.
✅ B is correct. Expected debt payoff = 0.5×1,000,000 + 0.5×300,000 = $650,000.
✅ A is correct. If success: equity = 1.3 − 1.0 = 0.3m; if failure: 0; expected = 0.5×0.3 = $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.
✅ 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.
✅ C is correct. Levered value = 600 + 30 − 10 = $620 million.
✅ A is correct. When tax benefits equal total costs, the optimal leverage is reached—net gain is zero.
✅ D is correct. Added distress cost outweighs tax benefit → net effect = −5 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.
✅ 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.
✅ C is correct.
Expected value = 0.6×600 + 0.3×(600−40) + 0.1×(600−150) = 556 million.
✅ B is correct. Expected cost = 0.2×60 = 12; 12 / 400 = 3%.
✅ A is correct. Expected distress cost = 0.25×100 = 25 → Net = 30 − 25 = +5 million.
✅ D is correct. Expected cost = 0.15×300 = 45 → Net impact = 40 − 45 = −5 million.
✅ C is correct. Value saved = 60×0.08×0.75 = 3.6 million. Debt can discipline managers by reducing waste.
✅ 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.
✅ A is correct.
If only low-quality firms issue, the market updates beliefs → price = $70, the value of low-type shares.
✅ D is correct.
Choosing debt signals confidence → market infers firm is high-type (value $120).
✅ B is correct.
Expected debt payoff = 0.5×80 + 0.5×50 = 65 → vs. 75 from safe assets → loss = 10.
✅ 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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