The correct answer for each question is indicated by a

Top of Form

.
1571867 1

Multiple Choice Q no 0073105902 1 5

Capital Structure: 16

1 CORRECT

Which of the following statements correctly describe bankruptcy? I. Bankruptcy is costly. II. Bankruptcy occurs when a firm's debts exceeds the value of the firm's assets. III. Bankruptcy transfers the ownership of a firm to the firm's creditors. IV. The value of a firm is diminished during the bankruptcy process. I and IV only A)

II and III only B)

I, II, and III only C) II, III, and IV only D)

I, II, III, and IV E)

2 5

Feedback: You are correct!

2 CORRECT

It is logical for shareholders to forego a positive net present value project when the: gain from the project must be shared with the bondholders. A) net return to the shareholders is positive. B)

benefit to the shareholders is less than the cost they incur. C) firm may go bankrupt shortly after the project ends. D)

odds of bankruptcy exceed 50 percent. E)

3 5

Feedback: You are correct!

3 INCORRECT

Cocoa Express is a levered firm which plans on closing one year from now. At that time, the firm will have to pay $6,300 in principal and interest on its outstanding bonds. Management feels there is a 65 percent probability that the firm's last year will be good and if so, the firm should produce a cash flow of $7,900 for the year. If they have a poor year instead, the annual cash flow will only be $5,700. The shareholders have the option of investing $1,000 today in a new project which is expected to return $1,200 at the end of the year. The shareholders should _____ the new project because they _____. accept; have an expected gain of $490 from the project A)

accept; have an expected gain of $210 from the project B)

accept; have an expected gain from the project of $90 C) reject; will gain nothing from the project D)

reject; will actually lose $10 on the project E) Feedback: The shareholders are expected to lose $10 on the
4 5

project. Review section 16.1.

4 INCORRECT

Downtown Fine Arts has been in business for the past five years, but Kate, the sole shareholder, wishes to close the business and retire after just one more year. She feels there is a 60 percent probability that the final year will be exceptional and if so, the firm will generate a cash flow of $91,000 for the year. On the other hand, there is a 40 percent probability that the year will be just normal, in which case the annual cash flow is projected at $68,000. There is one bond outstanding which will require a cash outflow of $76,000, including interest, at the end of the year. What is Kate's expected cash flow for the year? $3,600 A)

$4,500 B)

$6,000 C) $9,000 D)

$15,000 E) Feedback: Kate has a 60 percent chance of receiving $15,000.

5 5

Review section 16.1.

5 CORRECT

Joacquin International is a levered firm which is going out of business one year from now. The firm has debt outstanding which is due one year from now in the amount of $8,700, principal and interest. The shareholders have the option to continue operating the firm as is for its final year, or investing $1,100 in a new project which is expected to return $1,500 at the end of the year. The outlook for the firm, excluding the new project, is for an annual cash flow of $14,200 if the economy is good and $7,300 if the economy is poor. The probability of a good economy is 85 percent and the probability of a poor economy is 15 percent. The expected return to the shareholders without the new project is _____ and with the new project is _____. $4,675; $4,865 A)

$4,675; $5,965 B)

$4,675; $6,175 C) $4,885; $4,865 D)

$4,885; $5,965 E)
6 5

Feedback: You are correct!

6 INCORRECT

Denver Interiors has an expected cash flow of $47,000 if business this next year is good and an expected cash flow of $31,000 if business is slack. There is a 40 percent chance of a good year and a 60 percent chance of a slack year. The firm has principal and interest due on its debt of $35,000 at the end of the year. This will be the firm's final year of operations. Shareholders should expect to receive _____ at the end of the year and bondholders should expect to receive _____. $4,800; $32,600 A)

$4,800; $35,000 B)

$12,000; $32,600 C) $12,000; $35,000 D)

$16,000; $35,000 E) Feedback: The shareholders should expect to receive 40 percent of

7 5

$12,000. Review section 16.1.

7 INCORRECT

Legacy Furniture is on the verge of bankruptcy. The firm owes $29,000 to its creditors one year from now. Today, the firm is basically out of cash but does expect to generate cash over the next year. There is a 45 percent chance the firm can generate $46,000 of cash flows and a 55 percent chance of generating a cash inflow of $26,000. The shareholders have decided to remain open for one more year and then close permanently. What the shareholders are trying to decide now is whether they should invest $2,400 in a new project which is expected to return $4,000 one year from now. Which one of the following statements is correct given this situation? Without the new project, the shareholders expect to receive A)$17,000 from the final year's operations. The bondholders will be paid in full regardless of the performance B)of the firm or the acceptance of the project. The project will increase the expected return to the shareholders by $850.

C)

The shareholders are better off by $50 if they reject the project. D)

The shareholders are better off by $150 if they accept the project. E) Feedback: The shareholders are better off rejecting the project because the cost of the project to them outweighs the benefits they
8

would receive by $50. Review section 16.1.

5

8 INCORRECT

Which one of the following is a direct cost of bankruptcy? costs incurred because suppliers demand payment in cash A)

costs incurred because suppliers stop providing supplies to the firm B) restrictions on the firm's access to bank loans

C)

costs incurred from hiring bankruptcy attorneys D) lost potential profits because positive net present value projects are foregone

E)

Feedback: This is an indirect cost of bankruptcy. Review section

9 5

16.2.

9 INCORRECT

If a firm has a very high probability of bankruptcy, the shareholders will tend to prefer _____ risk projects financed with debt because _____. low; they can not afford the economic loss should the project fail A) low; they need projects with a high probability of success even if B)the potential rewards are small normal company; they need to continue operating the company as near to normal as possible

C)

medium; the firm can not afford too much risk but yet needs to D)earn some economic profits high; the bondholders are more apt to suffer any economic losses incurred should the project fail

E)

Feedback: Shareholders will prefer high-risk projects as they have nothing to lose but potentially have something to gain. Review
10 5

section 16.2.

10 CORRECT

The reason shareholders prefer high-risk, debt financed projects when a firm is facing bankruptcy is the fact that: shareholders are the residual owners of the firm. A)

bondholders are most apt to agree with high-risk projects but B)reject lower-risk projects. shareholders have nothing to gain or lose so are generally willing to support the bondholders' preference for high-risk projects.

C)

the firm needs to increase its earnings so new fixed assets can be D)acquired. the firm will need cash to hire bankruptcy attorneys and accountants.

E)

Feedback: You are correct!

Bottom of Form