|I. True/False (12 points)
Indicate whether the statements below are true or false. If the answer is true, explain why
it is true. If the answer is false, explain why it is false. Explain your answer in a
maximum of four sentences. Although there may be a variety of reasons answers are true
or false, I am looking specifically for reasons discussed in the lectures, readings, and
cases of this course.
A. In the APV, we should always discount the debt tax shield using the required return on
debt, because the debt is generating the tax shield, and so the risk of the tax shield is best
discounted by the risk of the debt. (3 points)
Answer: False. We can use either the required return on assets or the required return on debt to discount the DTS. We use the required return on assets if we are worried that
there may not be positive earnings against which a tax shield is useful. We use the
required return on debt if we are sure there will always be sufficient earnings so that a tax shield will always be useful.
B. Risk shifting refers to a situation in which management attempts to benefit
shareholders by issuing debt that is equal or higher seniority than existing debt, and
paying out proceeds to shareholders. (3 points)
Answer: False. Risk shifting refers to management’s tendency to take on risky projects when close to kink point in the call option that equity holders have on the firm. In other words, it is the tendency of management to expand volatility which we know increases the
value of a call option. The above agency cost in the question represents a wealth transfer.
C. Performance-based compensation always improves the incentives of managers of
public firms. Therefore, compensation of all CEOs should be 100% performance-based,
with little or no salary component. (3 points)
Answer: False. We have seen two reasons in class why 100% performance-based
contracts are not optimal. First, managers may not have complete control over the
“performance” that we measure. If they are risk-averse, then 100% performance-based
contracts will not be optimal. Second, if we choose the wrong performance benchmark,
for example the stock price, we can actually worsen incentives (encourage earnings
D. When a firm gets downgraded from investment grade to speculative grade, the only
meaningful change in their debt contracts is an increase in the interest spread. (3 points)
Answer: False. As we talked about in class 18, there is a dramatic increase in the
incidence of both non-financial and financial covenants when a firm gets downgraded.