MBAD 6235-80P and IAFF 6193-80

Capital Structure Summary and Conclusions

Student’s name: ______________________________

1- Examples of indirect costs financial distress are:

Impaired ability to conduct business.
Incentive to take on risky projects.
Incentive toward underinvestment.

2- Because financial distress costs are substantial and the stockholders ultimately bear them,
firms have an incentive to reduce costs. Protective covenants and debt consolidation are
two common cost reduction techniques.

3- Because costs of financial distress can be reduced but not eliminated, firms will not finance
entirely with debt

4- Signaling theory argues that profitable firms are likely to increase their leverage because the
extra interest payments will offset some of the pretax profits. As such, Rational stockholders
will infer higher firm value from a higher debt level. Thus, investors view debt as a signal of
firm value.

5- Managers owning a small proportion of a firm’s equity can be expected to work less,
maintain more lavish expense accounts, and accept more pet projects with negative NPVs
than managers owning a large proportion of equity.

6- Because new issues of equity dilute a manager’s percentage interest in the firm, such
agency costs are likely to increase when a firm’s growth is financed through new equity
rather than through new debt. Remember that Agency costs are internal costs incurred due
to the competing interests of shareholders (principals) and the management team (agents).

7- The pecking-order theory implies that managers prefer internal to external financing. If
external financing is required, managers tend to choose the safest securities, such as debt.

8- If distributions to equity holders are taxed at a lower effective personal tax rate than are
interest payments, what happens to the tax advantage to debt? a– offset; b- partially offset;
c- not affected

9- Debt–equity ratios vary across industries. The three factors determining the target debt–
equity ratio are:
a) Taxes: Firms with high taxable income should rely more on debt than firms with low
taxable income.
b) Types of assets: Firms with a high percentage of intangible assets such as research and
development should have low debt. Firms with primarily tangible assets should have
higher debt.
c) Uncertainty of operating income: Firms with high uncertainty of operating income should
rely mostly on equity.