CFS capital structure - limits to the use of debt

Q1: What is the difference between bankruptcy risk and bankruptcy cost?

A: Bankruptcy risk is the probability of default; bankruptcy cost is the actual expense incurred (legal, administrative, lost business), which reduces firm value.

Q2: What are direct costs of financial distress?

A: Legal, administrative, and court-related costs during bankruptcy.

Q3: What are indirect costs of financial distress?

A: Loss of customers, suppliers, or employee confidence; impaired operations and investment opportunities.

Q4: What are the three "Selfish Strategies" (Agency Costs of Debt)?

A: 1) Asset substitution. 2) Underinvestment. 3) Milking the property

Q: Asset substitution.

A. taking large risks at shareholders' expense

Q: Underinvestment

A: rejecting positive NPV projects to protect debtholders

Q: Milking the property

A: paying excessive dividends to equity holders before debt obligations

Q5: What are protective covenants?

A: Legal agreements in debt contracts designed to protect lenders from risky or value-reducing actions by borrowers.

Q6: What is a negative covenant? Give examples.

A: Restrictions that prevent certain borrower actions, e.g., limiting dividends, restricting additional debt.

Q7: What is a positive covenant? Give examples.

A: Requirements the borrower must fulfill, e.g., maintaining minimum working capital, providing periodic financial statements.

Q8: What does the (Static) Trade-off Theory state?

A: Firms balance the tax benefits of debt against the costs of financial distress; optimal debt occurs where marginal benefit = marginal cost.

Q9: What is the Signalling Theory of Capital Structure?

A: Financing choices send signals to the market: debt issuance signals confidence in future cash flows; equity issuance may signal overvaluation or lack of internal funds.

Q10: How do high debt-equity ratios affect agency costs of equity?

A: High leverage disciplines managers by reducing free cash flow, limiting wasteful spending (reduces Type I agency problems).

Q11: What is the Pecking Order Theory?

A: Firms prefer financing in this order: internal funds → debt → equity. There is no target capital structure; it evolves from past financing decisions.

Q12: What factors influence a firm's debt-to-equity ratio in practice?

A: Taxes and profitability, type of assets (tangible vs. intangible), and uncertainty of operating income.