End of the current year for mature firms or declining

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end of the current year. For mature firms or declining firms, deferred tax liabilities can be treated as an interest-free debt from the government (Internal Revenue Service) that may be repaid in the near future. However, for rapidly growing firms, deferred taxes are unlikely to reverse any time soon, making it more like equity. Preferred stock may be treated as equity. Despite the fact that preferred stock offers a fixed dividend like debt, the payment of dividend depends on management’s discretion. When the company is seriously short of cash, management can decide to pay the preferred stock dividend in the next period. Like common stock, preferred stock does not have a final principal payment date. Also, preferred stockholders cannot force the company that skipped dividends to bankruptcy. Convertible debt gives its owner the option to exchange the bond for a predetermined number of common shares at a fixed price. When the convertible debt holders decide to exercise their option to buy common stock, they just exchange the convertible debt with common stock. Convertible debt is treated as debt until it is converted to common stock. 2 . U.S. public companies with “low” leverage have an interest -bearing net debt-to-equity ratio of 0 percent or less, firms with “medium” leverage hav e a ratio between 1 and 62 percent, and “high” leverage firms have a ratio of 63 percent or more. Given these data, how would you classify the following firms in terms of their optimal debt-to-equity ratio (high, medium, or low)?
revenues and earnings are not sensitive to the fluctuations in the economy. In addition, an electric utility company typically has large tangible assets to provide security for lenders. Manufacturer of consumer durables. Medium debt-to-equity ratio. A manufacturer of consumer durables is faced with medium level competition. Its main assets include equipment (tangible assets) and technology (intangible assets); the cost of financial distress is medium. Commercial bank. High debt-to-equity ratio. Commercial banks have a high proportion of liquid assets. Further deposit insurance reduces depositors’ risk. Start-up software company. Low debt-to-equity ratio. A start- up software company’s business risks, similar to that of a pharmaceutical company, are relatively high and its assets can be easily destroyed by financial distress.

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