LOS j: Identify and explain the costs of financial distress, the agency costs and net agency costs of equity, the costs of asymmetric information, and their relation to a company’s optimal capital structure. fficeffice" />

Q1. Rupert Jones, a manager with Oswald Technologies, is confused about agency costs of equity and how they can be managed at his firm. To try to gain a better understanding about agency costs, Jones asks Karrie Converse, a well known consultant for an explanation. In their conversation, Converse makes the following statements:

Statement 1: Costs related to the conflict of interest between managers and owners of a business can be eliminated through a combination of bonding provisions and adequate monitoring through a quality corporate governance structure.

Statement 2: The less a company depends on debt in its capital structure, the lower the agency costs the company will tend to have.

Are Converse’s statements concerning the agency costs of equity correct?

A)   Both are incorrect.

B)   Both are correct.

C)   Only one is correct.

Correct answer is A)

Both of Converse’s statements are incorrect. With regard to elimination of agency costs, residual losses may occur even with adequate monitoring and bonding provisions, because such provisions do not provide a perfect guarantee against losses. Also, if you read the statement carefully, it is contradictory because the costs associated with bonding insurance and monitoring are actual agency costs! The second statement is also incorrect because, according to agency theory, the use of debt forces managers to have discipline with regard to how they spend cash. This discipline causes greater amounts of leverage to correspond to a reduction in agency costs.

Q2. Which of the following companies is most likely to have the greatest expected cost of financial distress?

A)   An airline company with strong management.

B)   A steel manufacturer with an average debt to equity ratio for the industry.

C)   An information technology service provider with a weak corporate governance structure.

Correct answer is C)

The expected cost financial distress is related to the combination of the cost and probability of financial distress. Firms who have a ready secondary market for their assets such as airlines or steel manufacturers, have lower costs from financial distress due to the marketability of their assets. Firms with fewer tangible assets, such as information technology service providers, have less to liquidate and therefore have higher costs related to financial distress. The probability of financial distress is positively related to the amount of leverage on the balance sheet, and negatively related to the quality of a firm’s management and corporate governance structure.

Q3. Which of the following is least likely to be categorized as a cost of financial distress?

A)   Legal fees paid to bankruptcy lawyers.

B)   Premiums paid for bonding insurance to guarantee management performance.

C)   Having a potential merger partner pull out of a proposed deal.

Correct answer is B)

Premiums paid for bonding insurance to guarantee management performance is an example of an agency cost. Agency costs are costs associated with the fact that all public companies are not managed by owners and the conflict of interest created by that fact. Costs of financial distress can be direct or indirect. Direct costs would include cash expenses associated with bankruptcy, such as legal and administrative fees, while indirect costs would include foregone business opportunities, inability to access capital markets, or loss of trust from customers, suppliers, or employees.

Q4. Steve Cooley, the Chief Financial Officer for Canberra Corporation, decides that he wants to use as much debt as possible in his firm’s capital structure. Cooley knows that to use more debt, he will need to make a persuasive argument to his board. Which of the following arguments used by Cooley to help with his goal of raising large amounts of additional debt is least supported by empirical evidence?

A)   Increasing the amount of debt has an insignificant impact on our credit risk premium.

B)   The cost of debt is always cheaper than the cost of equity.

C)   Raising additional debt provides a signal to our shareholders that our firm’s future prospects are positive.

Correct answer is A)

Athough it is not the only factor, increasing the amount of debt will put downward pressure on the company’s credit rating, resulting in an increase in the credit risk premium. This will in turn increase the costs of both debt and equity capital. Note that raising additional debt does provide a positive signal about future prospects. Also, saying that the cost of debt is always cheaper than the cost of equity is an accurate statement, but the static trade-off theory shows how balancing debt and equity capital can lead to lower costs for both components.