Module 9: True (T) or False (F) Questions
Last updated: 23/10/2025 14:12
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 1 (until Midterm)
| Module | Chapter | Slides | T/F | MCQ | Numeric | Long | Self-quiz |
|---|---|---|---|---|---|---|---|
| 9 | ch16 | 🎞️ | ✅ | ❓ | 🔢 | 📝 | 🧪 |
Mark T (True) or F (False) in each of the following sentences.
TRUE. Adverse selection happens when firms have private information that investors cannot access, causing the firm’s shares to be mispriced. This can make it more difficult for firms to raise funds at favorable terms.
FALSE. Larger firms often face more complex bankruptcy procedures, which can actually increase bankruptcy costs. However, they may have better access to financing during distress.
FALSE. Financial distress costs reduce the value of a firm. As the likelihood of distress increases, the firm’s value typically decreases because these costs create friction that erodes value.
FALSE. While tax benefits are important, the optimal debt level also considers the trade-off with financial distress costs. Too much debt can lead to increased bankruptcy risks.
FALSE. The Tradeoff Theory takes into account both the tax shield benefits of debt and the agency costs of debt, which can significantly influence a firm’s decision on its optimal capital structure.
TRUE. While Modigliani and Miller’s theorem holds in a perfect world, market imperfections like taxes and bankruptcy costs can cause deviations, making capital structure decisions relevant.
TRUE. Shareholders may benefit from increasing leverage because it can amplify their returns, even though it may increase the overall risk of the firm and reduce its total value.
TRUE. Managers often prefer debt to equity when they believe their stock is undervalued, as issuing equity could signal to the market that the company’s stock price is not as high as perceived.
FALSE. Agency costs, such as conflicts of interest between managers and shareholders or between equity holders and debt holders, are crucial in determining the optimal financing choice for the firm.
TRUE. With high leverage, debt holders have a priority claim on the firm’s assets, which may discourage equity holders from investing in positive-NPV projects if most of the value goes to the creditors.
TRUE. High levels of debt reduce the free cash flow available to managers, which limits their ability to engage in wasteful spending and reduces agency costs.
FALSE. Issuing new equity can signal that a company is overvalued or in need of cash, and investors may interpret this as a sign of weakness, not necessarily undervaluation.
TRUE. Debt covenants are often used to ensure that shareholders do not take actions that could harm debt holders, such as paying excessive dividends or engaging in risky investments.
FALSE. Taxes play a significant role in determining optimal capital structure, as the interest payments on debt are tax-deductible, providing a tax shield.
TRUE. By reducing the amount of free cash flow available, debt financing reduces the potential for wasteful spending by managers, thus lowering agency costs.
TRUE. As financial distress costs rise, firms tend to limit their debt levels to avoid the risk of bankruptcy and the associated costs, which can erode firm value.
FALSE. The optimal capital structure balances the tax benefits of debt with the financial distress costs. Maximizing the debt-to-equity ratio can lead to higher bankruptcy costs and lower firm value.
TRUE. Investors demand a higher return to compensate for the uncertainty and potential risk of hidden information, which leads to a higher cost of equity for firms facing adverse selection.
TRUE. The pecking order theory posits that firms prefer to use internal funds because they are less costly, followed by debt, and only issue equity when all other financing options are exhausted.
FALSE. Agency costs can also arise from conflicts between shareholders and managers, not just from debt financing. These costs occur whenever different stakeholders have conflicting interests.
TRUE. Issuing new equity can signal to the market that the firm believes its stock is overvalued, causing investors to adjust their expectations and potentially driving the stock price down.
FALSE. Information asymmetry leads to higher costs of issuing new securities because investors require a premium to compensate for the uncertainty about the firm’s true value.
TRUE. Short-term debt limits the amount of capital available to managers, which can reduce the likelihood of wasteful investments in long-term projects that do not maximize shareholder value.
TRUE. Debt covenants can limit dividend payments to prevent firms from distributing too much cash, which would reduce the funds available to repay debt holders in the event of financial distress.
FALSE. The free cash flow hypothesis argues that higher free cash flow increases agency costs, as it gives managers more discretion to engage in wasteful activities. More monitoring is needed to mitigate this risk.
TRUE. With high leverage, shareholders have incentives to take riskier projects since they enjoy the upside if successful, while debt holders absorb most losses if the firm fails.
TRUE. Debt payments reduce free cash flow, forcing managers to focus on value-creating activities instead of discretionary or inefficient spending.
FALSE. More debt reduces a firm’s financial flexibility because it increases fixed obligations and limits its ability to respond to future financing needs.
TRUE. According to the trade-off theory, when financial distress costs are significant, firms reduce debt usage to avoid value losses from distress and bankruptcy risk.
FALSE. Financial distress costs offset part of the tax advantages of debt, especially for firms with high leverage or volatile earnings.
TRUE. This trade-off defines the optimal capital structure: firms increase debt until the marginal tax benefit equals the marginal expected cost of financial distress.
TRUE. When a firm is highly leveraged, new projects primarily benefit creditors rather than shareholders, leading to underinvestment.
FALSE. Even in imperfect markets, firms choose between debt and equity based on factors like tax effects, risk, information asymmetry, and growth opportunities.
TRUE. Once debt is issued, shareholders may prefer riskier projects because they benefit more from potential upside, while debt holders bear much of the downside.
TRUE. Profitable firms often avoid excessive leverage because the potential costs of financial distress may outweigh the benefits of additional tax shields.
FALSE. Volatile cash flows increase the risk of financial distress, so these firms typically use less debt despite potential tax benefits.
TRUE. The trade-off theory states that firms balance the tax advantages of debt with the expected costs of financial distress to determine an optimal leverage level.
TRUE. High-growth firms avoid excessive debt because it can restrict future investments, leading to potential underinvestment when opportunities arise.
FALSE. Debt can reduce some agency conflicts, but it does not eliminate them. Other conflicts, such as those related to investment decisions, may persist.
TRUE. When the risk of distress is significant, firms often avoid additional debt even though it provides tax benefits, opting for safer equity financing.
TRUE. As the probability of distress rises, the tax advantages of extra debt are outweighed by expected distress costs, reducing the incentive to borrow.
FALSE. Agency conflicts can occur in any organization where ownership and control are separated, including small or private firms.
TRUE. Covenants protect lenders by limiting risky actions and align incentives between debt holders and shareholders.
TRUE. Managers avoid issuing equity if they believe it signals overvaluation, which could lead to a drop in stock price due to investor skepticism.
TRUE. Firms prefer internal financing to avoid signaling effects and costs of external financing, turning to equity only when necessary.
TRUE. Due to asymmetric information, issuing equity may signal overvaluation to investors, leading managers to favor debt or internal funding instead.
FALSE. The trade-off theory explicitly considers the costs of financial distress as a key factor in determining optimal leverage.
TRUE. After borrowing, shareholders may prefer riskier projects since potential gains benefit them, while debt holders bear most of the downside.
FALSE. Investor taxes influence preferences for debt or equity, as different instruments have distinct tax treatments that affect returns.
TRUE. Choosing to issue debt signals managerial confidence, since debt obligations require stable and predictable cash flows to be repaid.
TRUE. Legal and professional fees are direct outflows during bankruptcy that lower the total recovery value available to creditors and shareholders.
FALSE. Indirect costs like lost customers, employee turnover, and supplier distrust often exceed direct legal costs, severely impacting firm value.
TRUE. Optimal leverage is achieved when the marginal tax benefit of debt equals the marginal expected cost of financial distress.
FALSE. Beyond a certain point, additional leverage increases the probability of distress, which can offset or exceed the benefits from tax shields.
TRUE. Stable, asset-rich firms face lower bankruptcy risk, allowing them to sustain more debt to exploit tax advantages.
TRUE. Risk shifting and underinvestment are examples of shareholder actions that can hurt debtholders and reduce total firm value.
FALSE. During distress, managers may take excessive risks or avoid value-enhancing investments to protect their positions or short-term results.
TRUE. Leverage increases scrutiny from lenders and limits managerial discretion, reducing the likelihood of self-serving behavior.
TRUE. Regular debt payments discipline managers by reducing excess cash flow and increasing the cost of inefficient decisions.
FALSE. High-growth firms tend to rely on equity or internal funds to preserve flexibility and avoid the constraints imposed by debt.
TRUE. Firms that are more exposed to financial distress balance this risk by maintaining lower leverage to minimize expected costs.
FALSE. High leverage may reduce some conflicts but can also create new ones, such as risk-shifting and underinvestment problems.
TRUE. In debt overhang, shareholders avoid investing in valuable projects because most of the gains would go to creditors.
TRUE. Tangible assets can be sold more easily in distress, reducing uncertainty and recovery losses for creditors.
FALSE. According to the pecking order, firms first use internal funds, then debt, and issue equity only as a last resort.
TRUE. When investors suspect that managers have private information, they demand a discount, increasing the effective cost of equity issuance.
TRUE. Moderate leverage offers tax advantages and forces managers to act efficiently, both of which enhance firm value.
FALSE. Volatile earnings increase the probability of default, so such firms typically maintain lower debt levels.
TRUE. These indirect effects often exceed legal costs, reducing overall firm value during financial distress.
TRUE. By committing future cash to debt payments, firms prevent managers from using excess funds on unproductive projects or perks.
FALSE. Equity issuance is often interpreted as a negative signal, suggesting that managers think the firm’s shares are overvalued.
TRUE. Managers with positive private information may avoid equity issuance to prevent mispricing and dilution.
FALSE. High debt levels reduce financial flexibility and can limit a firm’s ability to take on new projects or respond to shocks.
TRUE. When ownership and control are separated, managers may act in their own interest unless incentives align with shareholders.
TRUE. Fixed interest payments force managers to allocate resources efficiently, reducing free cash flow misuse.
FALSE. Excess slack can lead to inefficiency and agency problems if managers use funds for unprofitable or self-serving projects.
TRUE. The pressure to make debt payments disciplines managers, reducing waste and aligning their interests with investors.
TRUE. Managers of strong firms may issue debt to show confidence in their ability to meet future interest obligations.
FALSE. Information asymmetry is central to financing choices, influencing whether firms issue debt or equity.
TRUE. Less profitable firms gain fewer tax benefits from interest deductions, making high leverage less attractive.
TRUE. High business risk increases the probability of distress, so firms compensate by using less debt to maintain stability.
FALSE. Although debt offers tax advantages, excessive leverage increases financial distress risk and may destroy firm value.
TRUE. With high leverage, shareholders have incentives to take risky investments that benefit them but can harm creditors.
TRUE. High debt can make shareholders reluctant to fund new investments if most of the benefits go to creditors.
FALSE. Bankruptcy costs reduce the overall firm value because part of the value is lost through legal fees and inefficiencies.
TRUE. Loss of trust and uncertainty during distress often lead to reduced sales, talent loss, and stricter supplier terms.
TRUE. When facing distress, managers might delay restructuring, reject risky projects, or manipulate earnings to preserve their jobs, even if those choices reduce total firm value.
FALSE. If a firm has low or negative earnings, it may not fully benefit from interest tax deductions, limiting the shield’s value.
TRUE. Under asymmetric information, equity issuance can signal overvaluation to the market, potentially leading to a drop in the firm’s stock price.
TRUE. The trade-off theory states that firms reach optimal leverage when the marginal tax benefit equals the marginal expected cost of distress.
TRUE. Covenants limit risk-taking or excessive payouts, aligning managerial behavior with creditor interests.
FALSE. Higher tax rates make the interest tax shield more valuable, often encouraging greater use of debt.
TRUE. Growth firms rely more on flexibility and equity because debt may discourage future investment.
TRUE. Reputation loss, contract renegotiation, and lost business can erode firm value before legal bankruptcy occurs.
FALSE. Firms use internal funds first and turn to equity only when both retained earnings and debt capacity are exhausted.
TRUE. Capital-intensive industries tend to borrow more, while volatile or intangible-based firms rely more on equity.
TRUE. Managers often value job security and may avoid debt that increases performance pressure or bankruptcy risk.
FALSE. The presence of debt changes shareholder behavior, often increasing incentives for riskier decisions.
TRUE. Easy access to capital markets reduces the need to hold precautionary cash balances.
TRUE. Optimal leverage is not fixed; it adapts as firm characteristics and market conditions shift over time.
Group 1 of 10