Capital Structure Theory: Agency Cost and Asymmetric Information

Question 1

Shareholders can gain by making negative-NPV investments or decisions that sufficiently increase the firm’s risk.

Which of the following best describes the agency cost above?

A
Asset substitution

B
Debt overhang

C
Cashing out

D
Managerial entrenchment

E
Asymmetric information

Answer 1

A
Asset substitution

A company replacing its low-risk assets with high-risk investments will experience what we refer to as the asset substitution problem. Shareholders prefer high-risk investments because of the potential for higher returns, whereas debt holders prefer less risk because their returns are fixed. Shareholders may benefit from high-risk projects, even those with negative NPV, but investing in a negative-NPV project reduces a firm’s total value.

Question 2

PV ( Financial distress cost) has 3 components. Which ones?

Answer 2

1) The cost of financial distress and bankruptcy, in the event they occur
2) Probability of financial distress and bankruptcy occuring.
3) The appropriate discount rate for distress coasts.

Question 3

Who pays the PV of financial distress cost?

Answer 3

Debt holders but shareholders pay it upfront

Question 4

Determine which of the following statements about the financial distress costs is FALSE.
A
When securities are fairly priced, the original debt holders of a firm pay the present value of the costs associated with bankruptcy and financial distress.

B
Technology firms are likely to incur high costs when they risk financial distress.

C
Real estate firms are likely to have lower costs of financial distress.

D
Utility companies are able to use high levels of debt and still have a very low probability of default.

E
The higher the firm’s beta, the higher the firm’s cost of capital.

Answer 4

A