Answers to Chapter Discussion Questions

Abstract

1. The trade-off theory is based on the premise that equity gains are taxed at the firm level, while interest payments can be expensed and hence are tax-advantaged. This unequal treatment of debt and equity creates the so-called tax shield of debt. Without offsetting costs, the tax advantage of debt would lead to pure debt financing. However, the tax advantage of debt is limited because firms have to consider two kinds of costs: bankruptcy and agency costs. Obviously, the higher a firm's leverage ratio, the higher is its probability of going bankrupt. Since bankruptcy or being near bankruptcy (financial distress) involves costs such as legal fees and loss in consumer confidence among others, firms cannot drive their leverage ratios excessively high. Accordingly, the trade-off theory predicts that firms pursue a target leverage ratio, where the marginal gains from the tax shield are equal to the marginal costs of bankruptcy. A similar argument can be made about agency problems. For example, managers have an incentive to maximize shareholder value at the expense of bondholders by engaging in risk shifting. Since bondholders anticipate this behavior, they will demand a risk premium on the issuing firm's cost of debt. Therefore, another version of the trade-off theory contends that firms have a target leverage ratio at which the marginal gains from the tax shield are equal to the marginal costs of incurring agency problems. 2. The pecking order theory assumes that managers have superior information compared to shareholders. Therefore, it predicts that firms prefer financing instruments with a low degree of information asymmetry because the compensation investors require for bearing adverse selection costs is smallest when information discrepancies are negligible. According to the pecking order theory , managers will prefer internal financing (without adverse selection costs) over debt financing and debt financing over equity financing (with the highest adverse selection costs of all financing instruments). The negative announcement returns of equity issues are the result of adverse selection. Rational investors assume that managers do not have an incentive to issue equity when they feel that their stock is undervalued. They only issue equity when they think that the firm is in a bad state and its equity is overvalued. Investors anticipate this behavior and perceive the announcement as a signal 445