Question

1. One way companies protect themselves from borrowing too much is to put aconstrain the bond rating, i.e., not allow the debt ratio to increase so much that therating (synthetic or estimated) drops below the rating constraint. For a non- financialservice company, that rating constraint is often investment grade (BBB). Which of thefollowing reasons explains this rating constraint?

		a. Your cost of debt can rise significantly once you drop below investmentgrade.
		b. If your rating drops below investment grade, your customers may hold backon buying your product or service.
		c. If your rating drops below investment grade, suppliers may be less willing toextend credit (and will demand cash instead)
		d. Your access to capital is more limited if you are not investment grade.
		e. All of the above.

2.

The argument for debt as a mechanism to discipline management is built around the premise that stockholders generally have little power over managers. If this argument holds true, a company that borrows more money should

		a. Invest more in good projects after the borrowing
		b. Invest less in good projects after the borrowing
		c. Invest more in bad projects after the borrowing
		d. Invest less in bad projects after the borrowing
		None of the above

3. Agency costs arise any time there is a conflict between stockholder interests andlender interests. Assuming that agency costs are high at a company, relative to the restof the market, which of the following would you expect to observe with the company’sborrowing?

		a. It will be able to borrow less than other companies
		b. It will have to pay higher interest rates on its loans than otherwise similar companies
		c. It will face more “covenants” than otherwise similar companies
		d. All of the above
		e. None of the above

4. A cost that has to be weighed into the debt decision is the expected cost of bankruptcy. As that cost rises, companies should borrow less money. Assume that you are looking at a European power company that has historically enjoyed monopoly power and has funded itself with a significant amount of debt. The power market has now been opened up to competition. What change would you expect to see in the company’s debt policy?

		a. None. It is still a profitable company
		b. Debt ratio should go up.
		c. Debt ratio should go down.

Answer 1

1. One way companies protect themselves from borrowing too much is to put aconstrain the bond rating, i.e., not allow the debt ratio to increase so much that the rating (synthetic or estimated) drops below the rating constraint. For a non- financial service company, that rating constraint is often investment grade (BBB). Which of thefollowing reasons explains this rating constraint?

Answer : e. All of the above

The argument for debt as a mechanism to discipline management is built around the premise that stockholders generally have little power over managers. If this argument holds true, a company that borrows more money should

Answer : d. Invest less in bad projects after the borrowing

Agency costs arise any time there is a conflict between stockholder interests andlender interests. Assuming that agency costs are high at a company, relative to the restof the market, which of the following would you expect to observe with the company’sborrowing?

Answer : d. All of the above

A cost that has to be weighed into the debt decision is the expected cost of bankruptcy. As that cost rises, companies should borrow less money. Assume that you are looking at a European power company that has historically enjoyed monopoly power and has funded itself with a significant amount of debt. The power market has now been opened up to competition. What change would you expect to see in the company’s debt policy?

Answer : c. Debt ratio should go down.