PRIN.OF CORPORATE FINANCE
13th Edition
ISBN: 9781260013900
Author: BREALEY
Publisher: RENT MCG
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Chapter 23, Problem 10PS
Summary Introduction
To determine: Whether the high value of each variables implies a high or low probability of bankruptcy.
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By using a graphic organizer of your choice, create a visual graphic that visually explains your response to the following:
A friend has mentioned that she has read that the following variables can be used to predict bankruptcy: (a) the company debt ratio; (b) the interest coverage; (c) the amount of cash relative to sales or assets; (d) the return on assets; (e) the market-to-book ratio; (f) the recent return on the stock; and (g) the volatility of the stock returns.
The problem is, she can’t remember whether a high value of each variable implies a high or a low probability of bankruptcy. Help your friend remember the information she needs to know by creating a visual graphic.
A friend has mentioned that she has read somewhere that the following variables can be used to predict bankruptcy: (a) the company debt ratio; (b) the interest coverage; (c) the amount of cash relative to sales or assets; (d) the return on assets; (e) the market-to-book ratio; (f) the recent return on the stock; (g) the volatility of the stock returns. The problem is that she can’t remember whether a high value of each variable implies a high or a low probability of bankruptcy. Can you help her out?
Suppose company Z is already in financial distress and the equity holders are very close to default. Suddenly there is a shock that causes an increase in the standard deviation of the return on company Z's assets. Which of the following correctly describes the new situation faced by company Z?
A) Debt value will increase with the shock and equity holder are more likely to default.
B) Equity value will increase with the shock and equity holder are less likely to default.
C) Both Debt value and equity value will increase but the likelihood of default is unchanged.
D) Both debt value and equity value will decrease and the likehood of default will increase.
Chapter 23 Solutions
PRIN.OF CORPORATE FINANCE
Ch. 23 - Expected yield You own a 5% bond maturing in two...Ch. 23 - Bond ratings In February 2018, Aaa bonds yielded...Ch. 23 - Bond ratings It is 2030 and the yields on...Ch. 23 - Prob. 4PSCh. 23 - Default option Other things equal, would you...Ch. 23 - Prob. 6PSCh. 23 - Prob. 7PSCh. 23 - Default option Digital Organics has 10 million...Ch. 23 - Prob. 9PSCh. 23 - Prob. 10PS
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- What is the value of Ls stock for volatilities between 0.20 and 0.95? What incentives might the manager of L have if she understands this relationship? What might debtholders do in response?arrow_forwardNext, we need to calculate MMMs cost of debt. We can use different approaches to estimate it One approach is to take the companys interest expense and divide it by total debt (which is the sum of short-term debt and long-term debt). This approach only works if the historical cost of debt equals the yield to maturity in todays market (i.e., if MMMs outstanding bonds are trading at dose to par). This approach may produce misleading estimates in years in which MMM issues a significant amount of new debt. For example, if a company issues a great deal of debt at the end of the year, the full amount of debt will appear on the year-end balance sheet, yet we still may not see a sharp increase in annual interest expense because the debt was outstanding for only a small portion of the entire year. When this situation occurs, the estimated cost of debt will likely understate the true cost of debt. Another approach is to try to find this number in the notes to the companys annual report by accessing the company's home page and its Investor Relations section. Alternatively, you can go to other external sources, such as bondsonline.com, for corporate bond spreads, which can be used to find estimates of the cost of debt. Finally, you can also go to Morningstar.com, which will provide yield to maturity information on the firms various bond issues. A longer-term issues YTM could provide an estimate of the firms current cost of debt to be used in the WACC calculation. Remember that you need the after-tax cost of debt to calculate a firm's WACC, so you will need MMMs tax rate (which has averaged around 30% in recent years). What is your estimate of MMMs after-tax cost of debt?arrow_forwardWhich of the following situations will most likely motivate managers to infl ate earnings inthe current period?A . Possibility of bond covenant violationB . Earnings in excess of analysts’ forecastsC . Earnings that are greater than the previous yeararrow_forward
- Which of the following statements is false? A. Banks have high levels of liquidity assets and stable funding since the financial crisis. B. Compared with bonds with short-term duration, bonds with long-term duration have uncertainty regarding future creditworthiness. C. Expected loss can decrease with an increase in a bond’s recovery rate. D. Macaulay duration is calculated as modified duration divided by one plus the bond’s yield to maturity.arrow_forwardSuppose the estimated linear probability model used by an FI to predict business loan applicant default probabilities is PD = .03X1+ .02X2 - .05X3+ error, where X1 is the borrower's debt/equity ratio, X2is the volatility of borrower earnings, and X3= 0.10 is the borrower’s profit ratio. For a particular loan applicant, X1= 0.75, X2= 0.25, and X3= 0.10. Required: What is the projected probability of default for the borrower? What is the projected probability of repayment if the debt/equity ratio is 2.5?arrow_forwardCOMPARISON What is the general trend of the company’s current liabilities? Did you observe any account with significant fluctuations? What could be the reason for this? What is the general trend of the company’s noncurrent liabilities? Did you observe any account with significant fluctuations? What could be the reason for this? What is the general trend of the company’s equity? Did you observe any account with significant fluctuations? What could be the reason for this?arrow_forward
- Describe clearly how theories from behavioural finance can justify the following abnormal phenomena of investment: (1) Investors exhibit tendency to overpay for assets with poor average return but a potential to deliver a huge payoff, such as penny stocks or corporate bonds of financially distressed companies. (2) Investors exhibit tendency to sell winning stocks too early but hold losing stocks for too longarrow_forwardQuestion 1 Indicate whether each of the following actions will increase or decrease a bond’s yield tomaturity: a. A bond’s price increase. b. The company’s bonds are downgraded by the rating agencies. c. A change in the bankruptcy code makes it more difficult for bondholders to receivepayments in the event a firm declares bankruptcy. d. The economy enters a recession. Question 2 .If a company’s beta were to double, would it expected return double? Question 3.Are there conditions under which a firm might be better off if it were to choose a machine with arapid payback rather than one with a larger NPV?arrow_forwardWould the market-value debt ratio tend to be higher than the book-value debt ratioduring a stock market boom or a recession? Explain.arrow_forward
- financial risk management fill in the blacks with correct answer. Interest rate risk is the potential for investment (....loss/gain..........). that result from a change in the interest rates. If interest rate (rise/fall)..., for instance, the value of the bond or fixed-income instrument will decline.arrow_forwardWhich of the following statements is false?(a) The quickest way to determine whether a firm has too much debt is to calculate the debt-to-equity ratio.(b) The best guideline to determine the firm's liquidity is to calculate the current ratio.(c) From the investor's point of view, the rate of return on common equity is a good indicator of whether the firm is generating an acceptable return to the investor.( d) We can determine the operating margin by expressing net income as a percentage of total sales.arrow_forwardWhich one is correct answer please confirm? Studies analyzing the historical returns earned by common stock investors have found that the returns from average risk common stock investments over very long time periods have averaged approximately ____ percentage points ____ than holding period returns on corporate debt issues. a. 5.7; higher b. 5.7; lower c. 7.5; higher d. 7.5; lowerarrow_forward
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