Question

1. A proposed debt agreement between SSC and its lender says that the cafe is not allowed to pay any dividends to its equity holders until the interest is paid to the lender each year. The yield to maturity is 8% on this proposed agreement. The cafe would like to get rid of this clause. What would happen to the yield to maturity without this clause?

A. It will most likely be more than 8%

B. still 8%

C. It depends on the Marginal tax rate

D. lower than 8%

2. Assume capital markets are perfect without frictions. Assume all people are risk averse. Which of the following is true?

A. Risk of equity increases even if the company has very low leverage ratito and increases leverage just by a little

B. Higher leverage will not change the return on equity

C. Higher leverage makes shareholders better off because they can enjoy higher rate of return

D. Higher leverage is good for equity holders up until a point. If leverage is too high, it starts being bad for shareholders.

Answer 1

1. Interest is paid to lenders. Shareholders are paid dividends. Here the clause states payment of interest first before giving out dividends. It lowers the risk for the lenders. Whatever is left after interest will be present for shareholders. When this clause would be removed it becomes risky for lenders as they may not get interest on time.

a. Is true. As risk increases, the cost of debt may be increased by lenders. Thus, yield is likely to be higher than 8%

b. Is false as for higher risk debtors are likely to demand higher return

c. Is false. Marginal tax rate would not matter. The yield would increase

d. Is false. It would be higher not lower.

2. All people are risk averse. Thus it means that people don't like risk.

a. Is true. Risk of equity increases even if the company has very low leverage ratio and increases leverage just by a little. As leverage increases, the risk of equity holders increases. Interest obligations are present with debt.

b. Is false.leverage would increase risk of equity holders. And higher return would be necessary.

c. Is false. Higher leverage increases risk. A risk averse person would not like additional risk. So shareholders are not necessarily better off.

d. Is false. If a capital market is perfect without friction then it is assumed that there are no taxes. If taxes are not present then this option becomes wrong. Higher leveeage is not good till any point. It will increase risk and risk averse person would not like it.

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