5283answers13.apr053 - 1 End of Chapter 13 Questions,...

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End of Chapter 13 Questions, Problems and Solutions CORPORATE FINANCE Professor Megginson April 5, 2003 Questions [See problems in book] *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** Answers to End of Chapter 13 Questions 13.1. The primary non-tax factors that influence capital structure are bankruptcy and agency costs and timing – whether the stock price is high or low. Firms facing higher bankruptcy and agency costs tend to have less debt in their capital structures. The effects of timing – issuing new equity when the stock’s price is high – can have lasting impacts on firms’ capital structures. 13.2. Firms with higher bankruptcy costs (higher risk firms) tend to have less debt in their capital structures. The lower level of debt reduces their overall risk. Firms with higher agency costs tend to have more debt in their capital structures. The higher level of debt tends to force managers to work harder to maximize value and keeps managers from mis-spending firm earnings. Firms do take advantage of timing – issuing stock when the market is high and debt when interest rates are low. 13.3. Limited liability is shareholders’ valuable default option. Shareholders have the right to walk away from a failed firm. The most that they can lose is their investment in the firm. Creditors cannot claim shareholders’ personal assets. In the event of bankruptcy, creditors must be satisfied with the value of the firm as their payment, even if that value is less than the face value of their original debt. The more a firm borrows, the less equity financing it requires. With a relatively low investment in the firm, the default option becomes quite valuable. If a firm invests in a risky project that turns out well, shareholders may enjoy a large positive gain. But if the project fails, shareholders only lose their original investment in the firm. 13.4. A software development firm would face higher costs of financial distress than the hotel chain. The main asset of the software development firm is the expertise of its programmers, an intangible asset. The hotel chain’s assets are its hotel properties. A lender can repossess and sell physical assets like hotels; it cannot repossess and sell human capital. In distress, the software company’s programmers may jump ship and move to another, healthier software business, and the firm will lose even more in value as its human assets leave. 13.5. Managers of financially distressed firms will have incentive to gamble with bondholders’ money. If little value will accrue to shareholders in the event of a liquidation, management, while still in control of the distressed company, may invest in highly risky projects (asset substitution) that have a small probability of a large payoff and a high probability of a zero or low payoff. This may give shareholders a small probability of increasing their wealth at the expense of bondholders. Shareholders also have little to no incentive to invest more equity into a failing company.
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5283answers13.apr053 - 1 End of Chapter 13 Questions,...

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