Q&A Hero

Q: A bank replaces 5-year corporate bonds with a yield to maturity of 9.75 percent with 5-year municipal bonds with a yield to maturity of 7 percent. This bank is in the 35 percent tax bracket and these bonds have the same default risk. What is the most likely reason this bank changed from the corporate to the municipal bonds? A) Liquidity risk B) Business risk C) Credit risk D) Tax exposure E) Interest rate risk

Q: What are some of the possible consequences of financial distress? I) Bondholders, who face the prospect of getting only part of their money back, are likely to want the company to take additional risks. II) Equity investors would like the company to cut its dividend payments to conserve cash. III) Equity investors would like the firm to shift toward riskier lines of business. A. I only B. II only C. III only D. I and II only

Q: Which of the following is true? Mortgage prepayment risk: A) Is higher on high interest rate mortgages B) Is felt most dramatically when interest rates rise C) Is eliminated by the use of mortgage backed securities D) Is eliminated by the purchase of a stripped mortgage obligation E) All of the above are true

Q: Which of the following statement(s) about financial distress is(are) true: I) always ends in bankruptcy II) firms can postpone bankruptcy for many years III) ultimately the firm may recover and avoid bankruptcy altogether A. I only B. II only C. II and III only D. III only

Q: A security where the interest payments and the principal payments are sold separately is called: A) A Treasury note B) An accretion C) A structured note D) A stripped security E) None of the above

Q: Indirect costs of bankruptcy are borne principally by: A. Bondholders B. Stockholders C. Managers D. The federal government

Q: Banks are generally not allowed to invest in speculative grade bonds. What kind of risk is this designed to limit? A) Liquidity risk B) Business risk C) Credit risk D) Tax exposure E) Interest rate risk

Q: According to the trade-off theory of capital structure: A. optimal capital structure is reached when the present value of tax savings on account of additional borrowing is just offset by increases in the present value of costs of distress. B. optimal capital structure is reached when stockholders' right to default is balanced by the the bondholders' right to get interest and principal payments. C. optimal capital structure is reached when the benefits of limited liability is just offset by the value of the lawyers' claim. D. none of the above

Q: In recent years security dealers have assembled pools of federal agency securities whose principal interest yield may be periodically reset based on what happens to a stated interest rate or may carry multiple coupon rates that are periodically adjusted; the foregoing describes a: A) Financial futures contract B) Revenue-anticipation note C) Zero coupon instrument D) Structured note E) None of the above

Q: When financial distress is a possibility, the value of a levered firm consists of: I) value of the firm if all-equity-financed II) present value of tax shield III) present value of costs of financial distress IV) present value of omitted dividend payments A. I only B. I + II C. I + II - III D. I + II - III - IV

Q: The lesson from the credit crisis of 2007-2009 is that securitized assets and credit swaps are: A) Complex financial instruments B) Difficult to correctly value and measure in terms of risk exposure C) Affected by cyclically sensitive markets in which financial problems may spread and result in a financial contagion D) Possible to set in motion a financial contagion that cannot be easily stopped without active government intervention E) All of the above are correct

Q: The value of the firm in the presence of debt may risk financial distress. Bankruptcy, the most severe type of financial distress, has an impact on value by: I) the risk or probability that it may occur II) the level of risk aversion investors have to debt III) the total value of the firm being siphoned off to cover bankruptcy costs A. I only B. I and II only C. III only D. II only

Q: The lesson(s) of the credit crisis of 2007-2009 is that the bankruptcy remote arrangement of the special-purpose entity (SPE): A) Reduces the need for securitization B) Eliminates the probability of bankruptcy of the originator institution C) May create problems if the underlying loans go bad in great numbers D) Eliminates the need for a trustee E) All of the above are correct

Q: The costs of financial distress depend on the: I) probability of financial distress II) corporate and personal tax rates III) the magnitude of costs encountered if financial distress occurs A. I only B. I and II only C. I, II and III D. I and III only

Q: What are the ways to reduce the risk of standby credit letters? A) Avoid renegotiating the terms of loans of SLC customers B) Specialize in SLCs issued by the same region and industry C) Sell participations in standbys in order to share risk with other lending institutions D) Do not count standbys as loans when assessing the banks risk exposure E) All of the above are the ways to reduce the risk

Q: Although the use of debt provides tax benefits to the firm, debt also puts pressure on the firm to: I) Meet interest and principal payments which if not met can put the company into financial distress II) Make dividend payments which if not met can put the company into financial distress III) Meet both interest and dividend payments which when met increase the firm cash flow IV) Meet increased tax payments thereby increasing firm value A. I only B. II only C. II and III only D. III and IV only

Q: What is the advantage of credit swaps for each partner? A) Broaden the number of markets B) Broaden the variety of markets from which they collect loan revenues and principal C) Spread out the risk in the loan portfolio D) Avoiding capital requirements E) A, B, and C

Q: The MM theory with taxes implies that firms should issue maximum debt. In practice, this is not true because: I) Debt is more risky than equity II) Bankruptcy and its attendant costs is a disadvantage to debt III) The payment of personal taxes may offset the tax benefit of debt A. I only B. II only C. III only D. II and III only

Q: According to research, off-balance-sheet standby credit letters reduce risk by: A) Increasing diversification of assets B) Reducing the need for documentation C) Reducing probability of losses D) Avoiding capital requirements E) Increasing concentration of risk exposure

Q: In Miller's model, when Personal tax rate on income from bonds is equal to the personal tax rate on income from stocks: A. relative advantage of debt depends only on the corporate tax rate B. relative advantage of debt depends only on the personal tax rate on interest income C. relative advantage of debt depends only on the personal tax rate on income from equity D. none of the above

Q: Regular collateralized debt obligations (CDO) have been surpassed by: A) Credit swaps B) Credit options C) Credit default swaps D) Total return swaps E) Synthetic collateralized debt obligations

Q: Corporate tax rate: 34% Personal tax rate on income from bonds: 10% Personal tax rate on income from stocks: 50% A. -$0.188 B. $0.340 C. $0.633 D. None of the above

Q: Which of the following is true regarding regulatory rules for standby credit letters issued by banks? A) They must list the standby credit letter as a liability on their balance sheet B) They do not have to list standby credit letters when assessing the risk exposure to a single credit customer C) They must apply the same credit standards for approving standby credit letters as direct loans D) They can apply lower capital standards to standby credit letters than loans E) None of the above is true

Q: Corporate tax rate: 34% Personal tax rate on income from bonds: 40% Personal tax rate on income from stocks: 30% A. $0.246 B. $0.340 C. $0.006 D. $0.23

Q: Which of the following is true regarding regulatory rules for standby credit letters issued by banks? A) They must list the standby credit letter as a liability on their balance sheet B) They must count standbys as loans C) They do not have to apply the same credit standards for approving standbys as direct loans D) They can apply lower capital standards to standbys than loans

Q: (Approximately) Corporate tax rate: 34% Personal tax rate on income from bonds: 30% Personal tax rate on income from stocks: 20% A. $0.66 B. $0.25 C. -$0.66 D. -$0.34

Q: Why have the use of standby credit letters grown in recent years? A) The growth of bank loans sought by companies in recent years B) The decreased demand for risk reduction devices C) The high cost of standby credit letters in recent years D) The rapid growth of direct financing by companies E) All of the above

Q: Suppose that a company can direct $1 to either debt interest or capital gains for equity investors. If half of equity income were subject to personal tax (e.g.: half is taxable dividends and half is tax-free capital gains) which investor would not care how the money is channeled? (The corporate tax rate is 35%) A. Investors paying zero personal tax B. Investors paying a personal tax rate of 53% C. Investors paying a personal tax rate of 17.5% D. None of the above

Q: What prompted a surge in loan sales in the 1980s? A) A wave of corporate buyouts B) An increase in lesser developed country loans C) A loosening of government regulations D) An increase in international lending E) None of the above

Q: In Miller's model, when the quantity (1 - TC)(1 - TpE) = (1 - Tp), then: A. The firm should hold no debt B. The value of the levered firm is greater than the value of the unlevered firm C. The tax shield on debt is exactly offset by higher personal taxes paid on interest income D. None of the above

Q: Which of the following is a concern regulators have about securitization? A) The risk of being an underwriter for asset-backed securities that cannot be sold B) The risk of acting as a credit enhancer and underestimating the need for loan-loss reserves C) The risk that unqualified trustees will fail to protect investors in asset-backed instruments D) The risk that loan servicers will be unable to satisfactorily monitor loan performance E) All of the above are concerns regulators have about securitization

Q: Suppose that a company can direct $1 to either debt interest or capital gains for equity investors. If there were no personal taxes on capital gains, which of the following investors would not care how the money was channeled? (The corporate tax rate is 35%) A. Investors paying personal tax of 17.5% B. Investors paying personal tax of 35% C. Investors paying personal tax of 53% D. None of the above

Q: According to the textbook, what is the minimum size of the loan-backed securities offering that are likely to be successful? A) $1 million B) $10 million C) $25 million D) $50 million E) $1 trillion

Q: For every dollar of operating income paid out as equity income, the shareholder realizes: A. (1 - Tp) B. (1 - TpE) (1 - TC) C. (1 - TC) D. None of the above

Q: What is one of the disadvantages of using loan backed bonds? A) The cost of funding often rises B) There is greater default risk on the bonds C) Loans used as collateral for the bonds must be held until the bonds reach maturity D) Loan backed bonds have shorter maturities than deposits E) All of the above are disadvantages of loan-backed bonds

Q: For every dollar of operating income paid out as interest, the bondholder realizes: A. (1 - Tp) B. (1 - TpE) (1 - TC) C. (1 - TC) D. None of the above

Q: The relative tax advantage of debt with personal and corporate taxes is: Where: TC = (Corporate tax rate) = 35%; TpE = Personal tax rate on equity income = 30%; and Tp = Personal tax rate on interest income = 20%: (approximately) A. 1.76 B. 1.16 C. 1.35 D. None of the given ones

Q: What is one of the advantages of using loan-backed bonds? A) Loans used as collateral for the bonds can be sold before the maturity of the bonds B) Loan-backed bonds have longer maturities than deposits C) Banks do not have to meet regulatory capital requirements on loans used as collateral D) Banks can use less loans as collateral than the amount of bonds issued E) All of the above are advantages of loan-backed bonds

Q: The relative tax advantage of debt with personal and corporate taxes is: Where: TC = Corporate tax rate; TpE = Personal tax rate on equity income; and Tp = Personal tax rate on interest income. A. B. C. D.

Q: In a collateralized mortgage obligation (CMO) a tranche: A) Promises a different return (coupon) to investors B) A liquidity enhancement C) Carries a different risk exposure D) A and C above E) All of the above

Q: Assume the corporate tax rate is 30%. The firm has no debt in its capital structure. It is valued at $100 million. What would be the value of the firm if it issued $50 in perpetual debt and repurchased the equity? A. $65 B. $115 C. $100 D. None of the above

Q: The coupon rate promised investors on securities issued against a pool of loans is 6.5%. The default rate on the pool of loans is expected to be 3.5%. The fee to compensate a servicing institution for collecting payments on the loan is 2%. Fees to set up credit and liquidity enhancements are 5%. The residual income on this pool of loans is 7%. What is the expected yield on this pool of loans? A) 24% B) 12% C) 10% D) 6.5% E) None of the above

Q: A group of pooled loans used is expected to yield a return of 23%. The coupon rate promised to investors on securities issued against the pool of loans is 8%. The default rate on the pooled loans is expected to be 4.5%. The fee to compensate a servicing institution for collecting payments on the loans is 2%. Fees to set up credit and liquidity enhancements are 3%. The fee for providing advising how to set up the pool of securitized loans is 1%. What is the residual income on this pool of loans? A) 18.5% B) 9% C) 4.5% D) 2% E) None of the above

Q: Assuming that bonds are sold at a fair price, the benefits from the tax shield go to the: A. managers of the firm B. bondholders of the firm C. stockholders of the firm D. lawyers of the firm

Q: MM's Proposition I corrected for the inclusion of corporate income taxes is expressed as: A. VL = VU B. VL = VU + D(1 - TC) C. VL = VU + (TC)(D) D. VU = VL + (TC)(D)

Q: Why are securitized loans often issued through a special purpose entity? A) Because the securitized loans often add risk to the bank and need to be held separately B) Because the securitized loans are not profitable for the bank and need to be held separately C) Because the special purpose entity might fail and this prevents the failure of the bank D) Because the bank might fail and this protects the credit status of the securitized loans E) All of the above

Q: Which of the following is an advantage of securitizing loans? A) Diversifying a lenders credit risk exposure B) Reducing the need to monitor each individual loans payment stream C) Transforming illiquid assets into liquid securities D) Serving as a new source of funds for lenders and attractive investments for investors E) All of the above are advantages of securitizing loans

Q: Bombay Company's balance sheet is as follows: (NWC = net working capital; LTA = long term assets; D = debt; E = equity; V = firm value): According to MM's Proposition I corrected for taxes, what will be the change in company value if Bombay issues $200 of equity and uses it to make a permanent reduction in the company's debt? Assume a 35% tax rate. A. +$140 B. +$70 C. $0 D. -$70

Q: When an issuer of securitized loans sets aside a cash reserve to cover loan defaults, they are providing an: A) Internal credit enhancement B) External credit enhancement C) Internal liquidity enhancement D) External liquidity enhancement E) None of the above

Q: MM Proposition I with corporate taxes states that: I) Capital structure can affect firm value by an amount that is equal to the present value of the interest tax shield II) By raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total value III) Firm value is maximized at an all debt capital structure A. I only B. II only C. III only D. I, II, and III

Q: When an issuer of securitized loans includes a standby letter of credit with the securitized loans, they are providing an: A) Internal credit enhancement B) External credit enhancement C) Internal liquidity enhancement D) External liquidity enhancement E) None of the above

Q: The positive value to the firm by adding debt to the capital structure in the presence of corporate taxes is: I) Due to the extra cash flow going to the investors of the firm rather than the tax authorities II) Due to the earnings before interest and taxes being fully taxed at the corporate rate III) Because personal-tax rates are the same as corporate tax rates A. I only B. II only C. III only D. II and III only

Q: The reason that MM Proposition I does not hold good in the presence of corporate taxes is because: A. Levered firms pay lower taxes when compared with identical unlevered firms B. Bondholders require higher rates of return compared with stockholders C. Earnings per share are no longer relevant with taxes D. Dividends are no longer relevant with taxes

Q: When an issuer of securitized loans divides them into different risk classes or tranches, they are providing an: A) Internal credit enhancement B) External credit enhancement C) Internal liquidity enhancement D) External liquidity enhancement E) None of the above

Q: Investors in securitized loans normally receive added assurance that they will be repaid in the form of guarantees against default issued by: A) The originator B) The special purpose entity C) The trustee D) The servicer E) The credit enhancer

Q: If a corporation cannot use its interest payments to get tax shield for a particular year because it has suffered a loss, it is still possible to get the tax shield because of the: I) carry back provision that allows corporations to carry back the loss and receive a tax refund up to the amount of taxes paid in the previous two years. II) carry forward provision that allows corporations to carry forward the loss and use it to shield income in subsequent years. A. I only B. II only C. I and II D. none of the above

Q: Someone who collects the payments on the securitized loans and passes those payments on to the trustee is called: A) The originator B) The special purpose entity C) The trustee D) The servicer E) The credit enhancer

Q: In order to calculate the tax shield effect of interest payment for a corporation, always use the: I) average corporate tax rate II) marginal corporate tax rate III) state mandated tax rate A. I only B. II only C. III only D. I and III only

Q: Someone appointed to ensure that the issuer fulfills all the requirements of the transfer of the loans to the pool and provides all of the services promised to investors in the securities is called: A) The originator B) The special purpose entity C) The trustee D) The servicer E) The credit enhancer

Q: If a firm borrows $50 million for one year at an interest rate of 9%, what is the present value of the interest tax shield? Assume a 30% tax rate. A. $50.00 million B. $17.50 million C. $1.445 million D. $1.239 million

Q: Loans that are to be securitized pass to . This helps ensure that if the lender goes bankrupt it does not affect the credit status of the pooled loans. A) The originator B) The special purpose entity C) The trustee D) The servicer E) The credit enhancer

Q: If a firm permanently borrows $50 million at an interest rate of 10%, what is the present value of the interest tax shield? Assume a 30% tax rate. A. $50.0 million B. $25.0 million C. $15.0 million D. $1.5 million

Q: The bank or other lender whose loans are pooled is called: A) The originator B) The special purpose entity C) The trustee D) The servicer E) The credit enhancer

Q: In order to calculate the tax shields provided by debt, the tax rate used is the: A. average corporate tax rate B. marginal corporate tax rate C. average of shareholders' tax rates D. average of bondholders' tax rates

Q: In order to find the present value of the tax shields provided by debt, the discount rate used is the: A. cost of capital B. cost of equity C. cost of debt D. none of the above

Q: The principal sellers of credit derivatives include all of the following except: A) Insurance companies B) Securities dealers C) Fund management firms D) Banks E) None of the above

Q: According to the text, in 2005 the securitization of loans reached: A) Million dollar market B) Billion dollar market C) Trillion dollar market D) Market unknown in value E) Small but growing market

Q: If a firm borrows $50 million for one year at an interest rate of 10%, what is the present value of the interest tax shield? Assume a 30% tax rate. (Approximately.) A. $1.364 million B. $1.5 million C. $1.0 million D. $4.545 million E. None of the above

Q: If a firm permanently borrows $100 million at an interest rate of 8%, what is the present value of the interest tax shield? (Assume that the tax rate is 30%) A. $8.00 million B. $5.6 million C. $30 million D. $26.67 million E. None of the above

Q: Bank use of credit derivatives is dominated by A) Community Banks B) The largest (over $1 billion) banks C) The retail banks D) None of the banks E) Banks do not use credit derivatives yet

Q: The main advantage of debt financing for a firm is: I) no SEC registration is required for bond issue II) interest expense of a firm is tax deductible III) unlevered firms have higher value than levered firms A. I only B. II only C. III only D. I and III only

Q: A bank has placed 5000 consumer loans in a package to be securitized. These loans have an annual yield of 15.25 percent. This bank estimates that the securities on these loans are priced to yield 10.95 percent. The bank expects 1.45 percent of the loans will default. Underwriting and advisory services will cost .25 percent and a credit guarantee if more loans default than expected will cost .35 percent. What is the residual income from this loan securitization? A) 3.70 percent B) 4.30 percent C) 2.25 percent D) 5.15 percent E) None of the above

Q: Student: ___________________________________________________________________________

Q: A bank has a long term relationship with a particular business customer. However, recently the bank has become concerned because of a potential deterioration in the customer's income. In addition, regulators have expressed concerns about the bank's capital position. The business customer has asked for a renewal of its $25 million dollar loan with the bank. Which credit derivative can help this situation? A) Credit swap B) Loan sale C) Loan securitization D) Credit risk option E) Credit linked notes

Q: Briefly describe the traditional position on capital structure.

Q: A bank has a limited geographic area. It would like to diversify its loan income with loans in other market areas but does not want to actually make loans in those areas because of their limited experience in those areas. Which type of credit derivative contract would you most recommend for this situation? A) Credit linked note B) Credit option C) Credit risk option D) Total return swap E) Credit swap

Q: A bank is concerned about excess volatility in its cash flows from some recent business loans it has made. Many of these loans have a fixed rate of interest and the bank's economics department has forecast a sharp increase in interest rates. The bank wants more stable cash flows. Which type of credit derivative contract would you most recommend for this situation? A) Credit linked note B) Credit option C) Credit risk option D) Total return swap E) Credit swap

Q: Briefly explain how changes in debt-equity ratio impacts on the beta of the firm's equity?

Q: A bank plans to offer new subordinated notes in the open market next month but knows that its credit rating is being reviewed by a credit rating agency. The bank wants to avoid paying sharply higher credit costs. Which type of credit derivative contract would you most recommend for this situation? A) Credit linked note B) Credit option C) Credit risk option D) Total return swap E) Credit swap

Q: State and explain MM's Proposition II.