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Real estate purchases are often financed with at least 80% debt. Most​ corporations, however, have less...

Real estate purchases are often financed with at least 80% debt. Most​ corporations, however, have less than 50% debt financing. Assuming that firms decide their capital structure by considering the tradeoff between the tax benefits of debt and the costs of financial distress, which of the following provides the most plausible explanation for this empirical observation?

Group of answer choices

The tax savings from debt are likely to be much higher for real estate transactions than for corporations.

Real estate assets can generally be easily resold at their full market​ value, whereas corporations typically face much higher distress costs.

It is impossible to finance real estate purchases using equity.

The financial distress costs of corporations are low because corporate assets are easy to​ liquidate, whereas real estate assets are difficult to resell.

Solutions

Expert Solution

A. Is wrong. The tax savings are not likely to be higher enough for real estate transactions than corporation to have this empirical observation

B. Is correct. Real estate has an active market. Many people invest in real estates. It diversifies the portfolio of investors. Thus, real estate can be easily sold for full value at market price if loan amount is not paid back. But if corporations fail, there is no active market to buy the corporation at its full value. Often also the valuation of firms are not certain. There is no market to discover its price with certainty. Everyone can have their own perception of risk and value the firm accordingly. Also, when a firm is unable to repay debt, it means it has profitability and cash issues. Therefore, cost of financial distress becomes too high. Thus, debt is generally observed to be around 50% in capital structure.

C. Is wrong. It is possible to purchase with equity.

D. Is wrong. Corporate assets are difficult to sell whereas real estate assets are easier as they have an active market.

jeff jeffy answered 1 year ago
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