PATTERSON KAREN AKWELE

10065093

LEVEL: 400
COURSE: FINANCIAL MANAGEMENT ( Self Assessment)

ACCOUNTING GROUP 2 (MORNING)

1. The optimal capital structure would differ from one industry to another because each
industry has a different level of business risk. The higher the level of business risk, the
lower the amount of financial risk that might be incurred and vice versa. Even within an
industry, the competitive position of a firm, the growth potential, and the caliber of
management may cause a higher degree of business risk.
2. Many factors influence the interest rate a firm must pay for debt funds. Some factors are
external to the firm. For example, the expected inflation rate, the Federal Reserve's
activity in the capital and money markets, and the productivity of capital, are external to
the firm. Other factors such as the magnitude and variability of earnings, the stability of
management, the debt-to equity ratio, type and quality of assets, bond rating, the maturity
of the bonds, and so on are internal factors that affect the rate paid on debt funds.
3. The total-value principle states that a corporation is valued on the basis of its earnings
potential and its business risk. The total "pie" of value stays the same regardless of how
it is sliced. Therefore, no matter how the pie is divided between debt, equity, and other
claims, the total value of the firm stays the same. There is a conservation of investment
value so that the sum of the parts equals the whole and the whole does not change with
changes in financial leverage.
4. Arbitrage implies that an identical product cannot sell for different prices in different
markets. If it does, arbitragers will buy in one market and sell in another to earn an
arbitrage profit with no risk to them. These actions will cause the price of one asset to
rise and the price of the other to fall until equilibrium is achieved, at which time there
will be no further opportunity for arbitrage profit. As applied to capital structure, if two
companies are said to be the same other than one is levered while the other is not,
arbitrage supposedly would cause the total value of the two firms to be the same. With
market imperfections, however, this need not be the case, though the elimination of
arbitrage profits is central to market equilibration as it applies, among other things, to the
issue of capital structure.
5. Without financial-market imperfections, variation in capital structure would have no
impact on share price. Capital structure decisions would be irrelevant, as suggested by
Modigliani-Miller.
Market imperfections take us away from a frictionless world and reduce the effectiveness
of arbitrage. As a result, different financial liabilities and common stock can have
different costs on a certainty-equivalent basis. The two most important imperfections
 with respect to capital structure are probably income taxes and bankruptcy costs. Their
joint impact was taken up in the chapter. Other imperfections include agency costs,
transaction costs on the sale of stocks and bonds by investors, flotation costs to the
corporation, legal restrictions governing investor behavior, and restrictions on margin
loans and short sales.
6. Bankruptcy costs include out-of-pocket expenses to lawyers, accountants, appraisers,
trustees, and others as well as the loss of economic value that often occurs as a company
approaches bankruptcy and is not able to operate efficiently. Agency costs include costs
of shareholders monitoring the actions of management and lenders monitoring the actions
of a company. Auditing fees, appraiser fees, bonding fees, and the cost of protective
covenants are examples of agency costs. These costs tend to increase at an increasing
rate beyond some point of financial leverage. Therefore, bankruptcy and agency costs
eventually offset the net tax benefit associated with the employment of debt funds by the
corporation. They bound the solution so that there is an optimal capital structure.
7. For reasons of prudence as well as legal reasons, institutional investors will not lend
money to a company that has excessive financial leverage. Both under state regulations
and ERISA, these investors cannot take excessive risks. Therefore, there comes a point
in financial leverage where they will not extend loans even though the firm may be
willing to pay a higher interest rate. The judgment of whether financial leverage is
excessive is usually made after studying debt ratios as well as the cash-flow ability of the
company to service debt. Often, regulators rely on the rating agencies to determine
whether a company is too risky when the debt is publicly held.
8. Without the payment of taxes, the corporate tax-shield due to debt disappears and so too
does the major economic argument to the use of debt. As a result, the optimal capital
structure would entail much less debt than if a company were to pay taxes at the full
corporate tax rate.
9. Debt financing would decrease on a relative basis, all other things the same. The tax
advantage associated with debt would be reduced. Equity financing would increase on a
relative basis, all other things the same.
10. The tax effect associated with debt and equity financing would be the same, as opposed
to the tax advantage presently enjoyed by debt financing. As a result, equity financing
would increase relative to debt financing. Corporations as a whole would move toward
lower debt-to-equity ratios.
11. If there is asymmetric information between management and investors, the former might
signal via capital structure. The implication is that management would not bind itself to
the debt servicing schedule unless it believed the company had operating cash flows in
the future to adequately service such debt. The capital-structure change represents an
explicit statement about expected future earnings. In this context, the issuance of debt is
"good news," whereas the issuance of equity would be regarded as "bad news" by
investors.