L4 - Empirical evidence

What are industries with less leverage?

• Startups

• Industries with volatile cashflows

• Industries with growth opportunities (want to invest in CAPEX)

• Industries with assets that cannot be sold easily

• Industries in which customers or suppliers care about the firm’s financial position

Elements determining high debt to equity ratio?

• Firm size (large ones, more leverage)

• EBITDA (proxy for past profitability)

• tangible assets

Elements determining low debt to equity ratio

• Market to book (proxy for investment opportunities)

• R&D expenses (proxy for information asymmetries and for investment opportunities)

• Past stock returns (proxy for past performance)

• Fewer tangible assets

• Small firms

Why do credit ratings matter?

• Affect bond pricing

• regulatory reasons

• contracts may be tied to rating

What happens when covenants loosen (in situation of asset substitution)?

the firm can now issue and invest more without violating covenants

increased debt and investment is at the expense of debt holders but benefit equity holders

What is the impact of asset substitution on firm value when covenants loosen? on equity and debt?

Firm value goes down (equity holders might decide to make risky investments)

Equity goes up

value of debt goes down (immediate price reaction)