Factors Affecting Optimal D/E Ratio

Question 1

Does the risk of bankruptcy affect the value of a company in a perfect capital market?

Answer 1

No.

Question 2

What is the effect of the risk of bankruptcy in a perfect capital market on the required return for debt capital?

Answer 2

Required return on debt might increase because of higher risk.

Question 3

What are the two types of bankruptcy?

Answer 3

1. Chapter 7 : liquidation

2. Chapter 11 : reorganization

Question 4

What are two alternatives to bankruptcy designed to avoid additional costs?

Answer 4

1. Workout

2. Prepackaged bankruptcy

Question 5

What is a “workout” bankruptcy?

Answer 5

The company works out an agreement directly with the creditors.

Question 6

What is a “prepackaged bankruptcy”?

Answer 6

The company works out a reorganization plan with the biggest creditors, the files for a chapter 11 reorganization and pressures smaller creditor to accept it.

Question 7

What are the indirect costs of bankruptcy?

Answer 7

1. Loss of customers
2. Loss of employees
3. Loss of suppliers
4. Loss of receivables
5. Fire sale of assets
6. Inefficient liquidation
7. Costs to creditors

Question 8

What is the highest financial distress cost for a company with high human capital?

Answer 8

Loss of employee

Less asset to liquidate

Question 9

What is the highest financial distress cost for a company selling long-term services?

Answer 9

Loss of customers

Question 10

Based on the trade-off theory, what is the optimal amount of leverage?

Answer 10

incremental value of tax shield = incremental cost of financial distress
(maximize PV(Tax Shield) - PV(FD costs))

Question 11

What causes the agency costs of leverage?

Answer 11

Conflicts of interest between management and creditors : management benefit from an increase in the stock price so might make decisions that benefit equity at the expense of debt.

Question 12

What are the agency costs of leverage?

Answer 12

1. Asset substitution problem

2. Debt overhang / under-investment problem

Question 13

What is the asset substitution problem?

Answer 13

Replacing safe investments with negative-NPT risky investments

Question 14

What is the debt overhang?

Answer 14

V1 : Failing to make positive NPV investments because it would not benefit equity holders (would only benefit debt holders).
V2 : Selling assets at low prices and using proceeds to pay dividends when the company is in FD.

Question 15

What is the effect of an increase in the level of leverage on the debt beta?

Answer 15

Debt tends to increase with leverage because debt gets more risky.

Question 16

What is the leverage ratchet effect?

Answer 16

Once a company has debt, it has an incentive to take on more debt, not to reduce it.

Question 17

Why are agency costs lower for short term debt?

Answer 17

Less opportunity to make suboptimal decisions before repaying the capital.

Question 18

What are agency benefit of leverage?

Answer 18

1. The control of the company is in fewer hands
2. Management has a greater share in equity
3. Management won’t waste money on empire building (less free cash)
4. Management is more likely to be fired if the company goes in FD
5. The company is more likely to compete because it is closer to bankruptcy otherwise

Question 19

Give the formula for trade-off theory.

Answer 19

VL = Vu + PV(Tax Shield) - PV(FD costs) - PV(Agency costs) + PV(agency benefits)

Question 20

What is the credibility principal?

Answer 20

Actions speak louder than words when words are in self-interest.

Question 21

Describe adverse selection.

Answer 21

Sellers with private information sell the least desirable items.

Question 22

What is the lemon principle?

Answer 22

Buyers discount price when sellers have private information.

Question 23

What are the effect of equity issue on the stock price:

1. at the announcement of the equity issue ?
2. before the announcement ?

Answer 23

1. Drop in stock price

2. Rise before announcement because company releases good news

Question 24

What is the pecking order hypothesis for financing projects?

Answer 24

1. Retained earnings
2. Debt
3. Equity