1. A firm has a significant amount of debt outstanding and its operations hit a rough patch. If it appears that bankruptcy is imminent, the firm’s management may invest in high-risk projects having a negative NPV because:
A. the firm’s equity beta is now negative.
B. the firm’s debt beta is now negative.
C. corporate income taxes are no longer a concern.
D. the firm’s debt holders bear most of the project’s downside risk.
2. The pecking order theory of capital structure predicts that firms will fund positive NPV projects first with internally generated funds, then with debt, and finally with new equity. What is the primary insight of the pecking order story theory that leads to this funding ordering in which equity is only issued as a last resort?
A. Issuing debt is always superior to issuing equity because interest paid to debtholders is tax deductible whereas dividends paid to shareholders are not.
B. The opportunity cost of internally generated funds is low in comparison to issuing new debt or equity because the alternative to retaining the funds and investing in new projects is to pay the funds out as dividends.
C. Issuing equity dilutes earnings per share.
D. Investors and managers are asymmetrically informed about the firm’s operations and value. There is an adverse selection cost of issuing equity because investors believe a firm is likely to issue equity when management believes the firm’s stock is overpriced.