Chapter 17

Question 1

Stakeholder theory

Answer 1

The way that a firm and its non-financial stakeholders interact should be considered when determining optimal CS because
The fear of a firm is going to fail actually causes it to fail.

Question 2

Stakeholder theory actions/results

Answer 2

• highly leveraged firms are seen as bad employers (don’t value good reputation, unlikely to offer employee growth due to lack of new projects, greater tendency to be laid off, likely to liquidate)
• highly leveraged firms may have low quality products, as they find cheaper alternatives to cover debt obligations
• don’t make enough revenue because stakeholders avoid doing business with them for fear of bearing liquidation costs (customers don’t do business with them, suppliers charge high prices, employees demand high wages)

Question 3

Financial distress is costly for:

Answer 3

Firms with
- products that need to be serviced in future
- products whose quality is importance but hard to observe
- where specialised training is required or specialised capital

Question 4

Benefits of financial distress

Answer 4

In a bilateral monopoly
- financial distress increases bargaining power. Firms say we can’t pay more wages because that’ll require more debt which is bad for you as our employee because we might go bankrupt
- bargaining with gov -> subsidize our operations because spillover effects will affect local or national economies and be bad for politics. Or our employees unions will rise and be bad for politics

Question 5

Financial predation

Answer 5

Taking advantage of a organization to serve your own interests

Question 6

Debt and predations

Answer 6

Competitor firms may purposefully lower their price to force a financially distressed firm into bankruptcy

Question 7

Debt financing and market share

Answer 7

High leverage can cause a firm to lose market share by:
1. Debt overhang problem I.e. underinvestment can force firm to sell off its assets
2. May not keep or attract customers because of bad rep
3. Competitors can view the firm as weak competition and steal its customers or eliminate the firm

Question 8

Static capital structure theory

Answer 8

CS are optimised period by period.
- CS decision: debt tax advantage in good state vs debt and financial distress costs in bad state -> think on these to get optimal CS

Question 9

Pecking order of financing choices

Answer 9

Pecking order of financing choices:
- finance investments with retained earnings NOT externally sourced funds
- adapt div policy to reflect anticipated investment needs
- pay off debt first with excess cash, then repurchase shares
- if external funding is needed: safest security first -> convertible bonds -> equity

Question 10

5 Reasons for pecking order

Answer 10

1. Taxes and TC considerations favor RE and D over E issues
2. Easier for managers to issue debt (don’t need board approval unlike with equity issue)
3. Issuing new equity sends a negative signal to investors
4. Debt overhang problem makes new equity issues less attractive
5. High leverage may help bargain and get concessions from employees and suppliers

Question 11

CS may be determined in part by firm history

Answer 11

Very profitable firms = increased equity value and lower debt
Unprofitable firms = lower equity value and increased debt

Baker and Wurger say this could just be market timing and there is no optimal CS

Question 12

CS choice relationships

Answer 12

• Profitability -> negatively related to leverage ration -> because pecking order description
• unionization -> positively related to leverage ratio (highly unionized industries are more levered) -> leverage increases firms bargaining power
• size -> positively related to leverage ratio (smaller firms take short term debt) -> TC of issuing LT debt and adverse incentive costs associated LT debt
• R&D/sales -> negatively related to leverage ratio -> tax reasons
• machines and equipment -> negatively related to leverage (less highly levered) -> customers don’t buy durable goods from financially distressed firms