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LOS p: Discuss international differences in financial leverage and the implications for investment analysis. fficeffice" />

Q1. Katherine Epler, a self-employed corporate finance consultant, is having a discussion with friends that are also in the corporate finance field. After talking about their families, the discussion turns to factors that tend to impact capital structure. During the course of the conversation, Epler makes two statements.

Statement 1: Favorable tax rates on dividend income relative to interest income will reduce the value of the tax shield provided by debt in the static trade-off theory of capital structure.

Statement 2: Evidence indicates that reductions in the net agency costs of equity tend to lead to lower financial leverage ratios.

With respect to Epler's statements:

A)   both are incorrect.

B)   both are correct.

C)   only one is correct.

Correct answer is B)

Epler’s first statement is correct. Miller (of Modigliani and Miller) concluded that if investors face different tax rates on dividend and interest income, the advantage for debt financing may be reduced somewhat. This conclusion is supported by international capital structure differences as countries with favorable dividend tax rates tend to use less debt in their capital structure. Epler’s second comment is also correct. When looking at international differences in capital structure, countries that have factors in place such as stronger legal systems and a greater presence of analysts and auditors tend to reduce agency costs and therefore also have lower financial leverage ratios. Note that higher leverage ratios tend to reduce agency costs, but reducing agency costs does not lead to higher leverage ratios.

 

Q2. Katherine Epler, a self-employed corporate finance consultant, is conducting a seminar concerning differences in financial leverage across different countries. In her seminar, Epler makes the following statements:

Statement 1: Companies in developed countries tend to use less long-term debt when financing their operations compared with companies in emerging markets.

Statement 2: Companies operating in ffice:smarttags" />Japan tend to have a greater reliance on shorter term debt financing than companies operating in the United States.

With respect to Epler’s statements:

A)   only one is correct.

B)   both are correct.

C)   both are incorrect.

Correct answer is A)

Epler’s first statement is incorrect. Companies in developed countries tend to use more long-term debt than emerging market countries. This makes sense because countries with more liquid capital markets (which would favor developed markets) tend to use more long-term debt. Epler’s second statement is correct. Japan relies on more short-term debt than the United States, which makes sense as the legal system and institutional investor presence tends to be greater in the U.S., which favors longer maturity debt.

 

Q3. The maturity structure for corporate debt is typically shorter in countries that have:

A)   more liquid stock and bond markets.

B)   low rates of GDP growth.

C)   lower rates of inflation.

Correct answer is B)

Firms operating in countries with higher GDP growth tend to use longer maturity debt, so firms with weaker economic growth will tend to use shorter maturity debt, all else equal. Note that low inflation means that longer maturity debt will do a better job holding its value, and that countries with highly liquid stock and bond markets will tend to use long maturity debt.

 

Q4. Financial leverage ratios tend to be to low in countries that have:

A)   a large institutional investor presence.

B)   a high reliance on the banking system for raising debt capital.

C)   inefficient legal systems.

Correct answer is A)

Firms operating in countries with an active, large institutional investor presence tend to have less financial leverage. Large institutional investors tend to have greater resources to analyze companies and reduce information asymmetries, which reduces the use of debt. By contrast, companies with weak legal systems and a high reliance on the banking system will all tend to have higher debt ratios.