Lecture 4 - Limits to the use of debt

Question 1

Why does the possibility of bankruptcy have a negative effect on the value of a firm?

Answer 1

The costs associated with bankruptcy lower the value of the firm rather than the risk of bankruptcy itself

Question 2

Financial distress costs

Answer 2

Direct costs
Indirect costs
Agency costs

Question 3

Direct financial distress costs

Answer 3

Lawyers
Expert witnesses
Administrative and accounting fees

Question 4

Indirect financial distress costs

Answer 4

Impaired ability to conduct business
Loss of trust
Who wants to deal with a firm that may go bankrupt?

Question 5

Agency costs

Answer 5

Underinvestment
Excessive risk taking
Milking the property

Question 6

Incentives to take large risks

Answer 6

In a boom, the increase in value accrues to shareholders
In a bust shareholders lose everything but they would even with low risk project
Because bondholders take the greater downside risk with a high risk project
Shareholders have an incentive to select high-risk projects at the expense of bondholders

Question 7

How can costs of debt be reduced?

Answer 7

Protective covenants
Consolidation of debt

Question 8

Protective (Restrictive) Covenants

Answer 8

An agreement that requires the borrower to either take or abstain from specific actions

Question 9

Pros and cons of protective covenants

Answer 9

Pros:
- Maintain working capital at. minimum level
- Furnish periodic statements to the lender

Cons:
- Limitations on the amount of dividends a company may pay
- Cannot merge with another firm
- Cannot issue additional long term debt

Question 10

Consolidation of debt

Answer 10

The act of combining several loans or liabilities into one loan to reduce conflicts

Question 11

Signalling theory

Answer 11

The benefit of the tax shield depends on the level of taxable profits
A firm with low profits is likely to take on low level of debt
A firm with higher profits is likely to take on more debt
Investors can read changing debt levels as a signal of firm value

Question 12

The pecking order theory

Answer 12

Firms prefer to use retained earnings to any other sources of finance because it is easier and cheaper
After that they will choose only equity as a last resort
Pecking order is
1. Retained earnings
2. Debt
3. Preference shares
4. Equity shares

Question 13

Implications of the pecking order theory

Answer 13

There is no target amount of leverage
Profitable firms use less debt
Companies like financial slack

Question 14

Market timing theory

Answer 14

Debt to equity ratios depend on the time that a firm needs funds
Firms will have more equity if they need funds when their market to book valuations are high
Firms will have more debt if they need funds in low market to book periods

Question 15

Capital structure in practice

Answer 15

Most firms have low debt to equity ratios
Some firms have no debt
Capital structures are unstable over time