Practice for Lecture 6: Tradeoff Theory & Other Theories
Questions 1-7 are simple background questions whose answers are in the notes:
Question 1. Consider the Modigliani-Miller world with no taxes or bankruptcy costs. Will the value of an unlevered firm differ from the value of a highly levered with a significant likelihood of going into bankruptcy firm? Why?
Question 2. What are the direct and indirect costs of financial distress / bankruptcy? How do these costs affect firm value?
Question 3. Who bears expected financial distress costs and why?
Question 4. Briefly explain the main ideas behind the following capital structure theories:
i) the trade-off theory
ii) the pecking order theory
iii) the signaling theory
iv) the stakeholder theory
Question 5. Briefly explain:
a) how a firm can strategically use debt financing when it faces committed stakeholders.
b) what stylized facts are consistent with the trade-off theory of capital structure and which would be consistent with the pecking order theory.
c) how higher leverage can affect a firm’s competitive position in product markets.
Question 6. If managers know the true value of a firm’s stock but outside investors do not, what will happen with stock prices upon the announcement of an equity issue and why?
Question 7. Describe what are the potential agency costs and benefits of debt financing. When would you expect these costs and benefits to be larger?
Question 8. ML Inc. is an all-equity firm with 10 million shares outstanding which trade at $15 per share, and it faces a 40% corporate tax rate. Although investors currently expect ML to remain an all-equity firm, ML plans to announce tomorrow that it will issue perpetual debt for an amount of $80 million and will use all the funds to repurchase shares. Market participants understand that with this new level of debt ML could become financially distressed some time in the future. They also understand that the...
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