Part 9 (ch16) Questions T/F & Multiple Choice

Mark T (True) or F (False) in each of the following sentences.

1 Adverse selection is a concern for firms when issuing new equity, and it refers to the potential presence of hidden information that can affect investor interest in newly issued shares.

2 Bankruptcy costs, including legal and administrative expenses, are typically lower for larger firms due to their financial strength.

3 An increase in financial distress costs would increase the total value of a leveraged firm.

4 In the context of optimal leverage with taxes and financial distress costs, the optimal debt level for a firm is solely determined by the tax benefits it can receive from interest deductions.

5 According to the Tradeoff Theory, agency costs play a minor role in a firm’s capital structure decisions.

6 According to the Modigliani and Miller theorem, market imperfections, such as taxes and bankruptcy costs, can lead to deviations from the theorem’s conclusions in a frictionless world.

7 Shareholders may have an incentive to increase leverage even if it decreases the value of the firm.

8 In the presence of information asymmetry, managers may prefer to finance with debt rather than equity to avoid signaling that their stock is overvalued.

9 Agency costs are irrelevant to the decision of whether to finance with debt or equity.

10 High leverage can lead to underinvestment problems if debt holders capture most of the benefits from new projects.

11 The free cash flow hypothesis suggests that higher debt levels can mitigate the agency costs of free cash flow by reducing the amount of cash available to managers for discretionary spending.

12 Issuing new equity always signals to the market that a firm’s stock is undervalued.

13 Debt covenants can help mitigate agency problems between shareholders and debt holders by restricting actions that would transfer wealth from debt holders to shareholders.

14 The presence of taxes has no impact on the optimal capital structure of a firm.

15 Debt financing can reduce agency costs of equity by limiting the free cash flow available to managers.

16 The presence of financial distress costs can limit the amount of debt a firm is willing to take on.

17 In a world with taxes and financial distress costs, the optimal capital structure is one that maximizes the firm’s debt-to-equity ratio.

18 Adverse selection can lead to a higher cost of equity because investors demand a premium for the risk of hidden information.

19 The pecking order theory suggests that firms prefer to finance new investments first with internal funds, then with debt, and finally with equity as a last resort.

20 Agency costs arise only in the presence of debt financing.

21 The signaling effect of issuing new equity can lead to a decrease in the firm’s stock price if investors believe the firm is overvalued.

22 Information asymmetry does not affect the cost of issuing new securities.

23 In the presence of agency problems, firms may use short-term debt to reduce the risk of managers engaging in suboptimal long-term projects.

24 Debt holders may impose covenants to restrict dividend payments in order to protect their interests.

25 The free cash flow hypothesis argues that higher levels of free cash flow reduce the need for monitoring management.

26 Equity holders may prefer riskier projects when the firm has high leverage because they benefit more from the upside, while debt holders bear more of the downside risk.

27 Debt can serve as a disciplinary mechanism for managers by reducing the funds available for wasteful expenditures.

28 Issuing debt has no impact on a firm’s financial flexibility.

29 The presence of personal taxes on interest income can affect the attractiveness of debt financing for investors.

30 Financial distress costs are typically irrelevant when considering the benefits of the interest tax shield.