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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.

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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.

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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.

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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.

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

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

B) Legal fees paid to bankruptcy lawyers.

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

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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.

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Bhairavi Patel, an analyst for major brokerage firm, is considering how to incorporate the static trade-off capital structure theory into her valuation models for companies she covers. Patel is discussing the static trade-off theory with her colleagues, and makes the following statements:

Statement 1: If a firm maintains a high debt rating, the firm cannot be at its optimal capital structure based on the static trade-off theory.

Statement 2: The static theory implies that differences in the optimal capital structure across similar firms in different countries must be the result of different tax rates in those countries.

With respect to Patel’s statements:

A) both are incorrect.

B) both are correct.

C) only one is correct.

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Neither of Patel’s statements is correct. Firms seek to maintain a high debt rating because it implies a lower probability of financial distress, which reduces the cost of debt and equity capital and leads to a higher value for the firm. Although a firm would not be at its optimal capital structure if it were not using enough debt, a firm can certainly have a large proportion of high quality debt that keeps the firm at its optimal capital structure while maintaining a high credit rating. The second statement is also incorrect. Although differences in tax rates can play a role in having different optimal capital structures for similar firms, differences in costs of financial distress will play a role as well. Differences in legal structure, liquidity, and other factors will result in different perceived costs of financial distress in different countries, which will in turn, contribute to different optimal capital structures according to the static trade-off theory.

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Katherine Epler, a self-employed corporate finance consultant, is working with another new client, Thurber Electronics. Epler is discussing the static trade-off capital structure theory with her client, and makes the following comments:

Comment 1: Under the static trade-off theory, the graph of a company’s weighted average cost of capital has a U shape.

Comment 2: According to the static trade-off theory, every firm will have the same optimal amount of debt that maximizes the value of the firm.

With respect to Epler’s comments:

A) both are correct.

B) both are incorrect.

C) only one is correct.

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Epler’s first comment is correct. When graphing a company’s WACC according to the static trade-off theory, the WACC will initially decline as a company increases its tax savings through the use of debt. However, as more debt is added, the WACC will reach a point where it increases due to the increasing costs of financial distress. Note that when graphing the static trade-off theory, the WACC looks like a U shape, while the value of the firm looks like an upside down U shape. This makes sense because the value of the firm is maximized when the WACC is minimized. Epler’s second comment is incorrect. Every firm will have a different optimal capital structure that will depend on the firm’s operating risk, tax situation, industry influences, and other factors.

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According to the static trade-off theory:

A) new debt financing is always preferable to new equity financing.

B) the amount of debt used by a company should decrease as the company’s corporate tax rate increases.

C) there is an optimal proportion of debt that will maximize the value of the firm.

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The static trade-off theory seeks to balance the costs of financial distress with the tax shield benefits from using debt. Under the static trade-off theory, there is an optimal capital structure that has an optimal proportion of debt that will maximize the value of the firm.

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Which of the following best describes the shape of the line depicting the value of a levered firm when plotted according to the static trade-off theory? Assume that the percentage of debt in the capital structure is the independent variable.

A) U shaped.

B) Always upward sloping.

C) Upside down U shaped.

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The line depicting the value of a levered firm according to the static trade-off theory looks like an upside down U. The value of the firm will initially increase due to the tax savings provided by taking on additional debt financing, and then will decline as the costs of financial distress exceed the tax benefits of taking on additional debt financing.

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Global Development expects to earn $6 million next year. 40% of this amount, or $2.4 million, has been allocated for distribution to common shareholders. There are 2.4 million shares outstanding, and the market price is $30 a share. If Global uses the $2.4 million to repurchase shares at the current price of $30 per share, its share price after the repurchase will be closest to:

A) $29.00.

B) $30.00.

C) $31.00.

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Market value of equity before the repurchase is $30 × 2.4 million = $72 million.

Shares Repurchased = $2.4 million / $30 = 80,000 shares.

Shares remaining = Shares outstanding ? Shares repurchased = 2,400,000 ? 80,000 = 2,320,000.

Share price after the repurchase = ($72 million ? $2.4 million) / 2,320,000 = $30.

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John Harrison is discussing the implications for Modigliani and Miller (MM’s) propositions (assuming no corporate or personal taxes) for manager’s decisions regarding capital structure with his supervisor, Harriet Perry. In the conversation, Harrison makes the following statements:

Statement 1: According to MM’s propositions, increasing the use of cheaper debt financing will increase the cost of equity and the net change to the company’s weighted average cost of capital (WACC) will be zero.

Statement 2: Since MM’s propositions assume that there are no taxes, equity is the preferred method of financing.

What is the most appropriate response to Harrison’s statements?

A) Agree with both.

B) Agree with neither.

C) Agree with one only.

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Perry should agree with the first statement. MM asserts that the use of debt financing, although it is cheaper than equity, will increase in the cost of equity, resulting in a zero net change in the WACC. Perry should disagree with the second statement. Although MM’s propositions assume that there are no taxes, the conclusion is that the mix of debt and equity financing is irrelevant and that there is no preferred method of financing.

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According to pecking order theory, which financing choice is most preferred, and which is least preferred?

Most preferred

Least preferred

A) Internally generated funds New equity

B) New debt New equity

C) Internally generated funds New debt

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Pecking order theory is related to the signals management sends to investors through its financing choices. Financing choices follow a hierarchy based on visibility to investors with internally generated funds being the least visible and most preferred, and issuing new equity as the most visible and least preferred.