Questions & explanations
1. Give an example of how shareholders might benefit from a risky project that debtholders would prefer the firm avoid.
Suppose a firm has $90 debt and assets worth $100. It can choose project A (safe) that makes $20 for sure, or project B (risky) that has a 50% chance of $50 and 50% chance of $0. If the firm takes safe A, total becomes $120, debtholders get $90, shareholders get $30. If the firm takes risky B, there is a 50% chance of $150 (shareholders get $60 after paying $90) and 50% chance of $100 (shareholders get $10 because firm is worth $100 but debt still $90? Actually, if project fails, firm value is $100, debt $90, equity $10). Expected equity for B: 0.5 * $60 + 0.5 * $10 = $35, which is higher than $30 from A. So shareholders prefer the risky project even though it has lower expected total value ($125 vs $120?). Wait, expected firm value for B: 0.5*150 + 0.5*100 = 125, for A: 120. So B is actually better for both? But if the project fails, debtholders still get $90, while if risky succeeds, they still get $90. So debtholders are indifferent. That example doesn't show conflict. Better: make debt risky. Suppose debt is $100, firm assets worth $80, so firm is in trouble. Project A: safe retu
2. What is the underinvestment problem? Provide an example.
The underinvestment problem occurs when a firm with risky debt passes up a positive-NPV project because most of the gain would go to debtholders. For instance, if the firm is near bankruptcy, any new investment is partly used to pay existing debt. Shareholders might not get enough return to make the project worthwhile. Example: A firm owes $90 in debt, but assets are worth $80. A project costing $10 will return $20 for sure. But after paying the debt, shareholders only get $10 ($100 - $90) while debtholders get $90. Without the project, shareholders get nothing. Actually, with project, firm value rises to $100, debtholders get $90, shareholders get $10, but they invested $10? Wait, to invest $10, shareholders must put in money or use cash. If they invest $10, their net gain is $10 - $10 = $0. So they are indifferent or even prefer not to invest because management might have other costs. The key: shareholders bear the full cost but share the benefit with debtholders.
3. Explain debt overhang. How does it affect a firm's investment decisions?
Debt overhang means a firm has so much existing debt that it cannot borrow more to fund good projects. New creditors would be junior to existing debt, so they demand high interest. The firm may also find that any new project's cash flows mostly go to existing debtholders, leaving little for shareholders. As a result, managers may reject profitable investments, hurting the firm's long-term value. For example, a firm with $100 debt and assets worth $80 sees a project that costs $20 and returns $40. The total becomes $120, debtholders get $100, shareholders get $20. But shareholders must find $20 from somewhere. If they already have $20 cash, they could invest, but they might prefer to hold the cash or pay dividends. So debt overhang can cause underinvestment.
4. What is risk-shifting? How does it differ from asset substitution?
Risk-shifting is the general term for shareholders taking on more risk after debt is issued to transfer wealth from debtholders. Asset substitution is one form of risk-shifting where the firm changes its assets to riskier ones. Risk-shifting can also include choosing riskier financial policies like paying high dividends or taking on more debt. Both increase the risk of default. The difference is that asset substitution specifically involves swapping assets for riskier ones, while risk-shifting covers any action that raises risk. Both are harmful to debtholders because they increase the chance of loss without compensating debtholders. Debtholders try to prevent this through covenants.
5. Why might a constant payout ratio policy be less common than a stable dividend policy?
A constant payout ratio policy is less common because it leads to fluctuating dividends that many investors do not like. Most shareholders prefer predictable income, especially retirees and pension funds. Also, dividend cuts, even when earnings drop, often cause the stock price to fall sharply. Managers worry that volatile dividends signal weakness or uncertainty. Additionally, companies prefer to smooth dividends over time to maintain a stable clientele. Constant payout can force a dividend cut in a bad year, which might be seen as a negative signal. Therefore, most firms choose a stable dividend policy with gradual adjustments, rather than a strict fixed ratio.
6. What is an advantage of a constant payout ratio policy compared to a stable dividend policy?
An advantage of a constant payout ratio policy is that it is easy to implement and transparent. The company simply pays a fixed fraction of earnings, so no complex decisions are needed each quarter. It also signals that dividends are tied to performance. When earnings are good, dividends are high, and when earnings are bad, dividends are low. This can help the company avoid cutting dividends unexpectedly. Another advantage is that it helps maintain a target capital structure, because the retained earnings automatically adjust. However, this policy can create volatile dividends, which some investors dislike compared to the stability of a constant dividend policy.
7. Compare principal-principal conflict with principal-agent conflict. How are they different?
Principal-agent conflict is between shareholders (principals) and managers (agents) who may act for themselves. Principal-principal conflict is between different groups of shareholders, such as controlling versus minority. In agency conflict, the problem is managers shirking or over-spending; in principal-principal conflict, the problem is the controlling owner exploiting their power. Agency conflict is common in widely-held firms, while principal-principal conflict is more common in firms with concentrated ownership, like family businesses. Solutions also differ: for agency, incentives and monitoring; for principal-principal, legal protections for minorities.
8. Why do firms following the pecking order theory not have a target debt ratio?
Firms following the pecking order do not have a target debt ratio because their leverage results from the cumulative need for external funds over time. They first use internal funds, then debt, then equity. So debt increases when investment needs exceed retained earnings, and decreases when earnings are high. The debt ratio is not deliberately chosen; it is the by-product of financing deficits. For example, a profitable firm may have low debt because it uses its earnings to fund investments. A suddenly unprofitable firm may issue debt to cover its needs. The pecking order theory explains why many firms' leverage ratios vary widely and are not mean-reverting.
9. How does adverse selection, as in the Myers-Majluf model, lead to a pecking order?
Adverse selection happens because managers have better information about the firm's value than new investors. If a firm issues equity to fund a project, investors fear the stock is overpriced. So they only buy at a discount, making the stock cheaper than its true value. This makes equity financing expensive for the firm. To avoid this, managers first use internal funds, which do not involve new investors. If internal funds are not enough, they issue debt, because debt is less mispriced than equity. Debt has a fixed claim, so its value depends less on information about future profits. Equity is the last choice because it suffers most from adverse selection.
10. What is meant by agency costs of debt?
Agency costs of debt are the costs that arise when the interests of shareholders and debtholders conflict. Shareholders control the firm's decisions but debtholders have lent money. Shareholders may take actions that benefit themselves at the expense of debtholders. These actions include taking on risky projects (asset substitution), refusing to invest in positive-NPV projects (underinvestment), or shifting risk to debtholders. Debtholders anticipate this and demand higher interest rates or impose restrictions. The total higher cost of debt and lost investment opportunities are the agency costs. These costs can reduce the amount of debt a firm can use.
11. What is the main prediction of the pecking order theory of capital structure?
The pecking order theory predicts that firms have a preferred order for financing investments. First, they use internal funds like retained earnings. If more money is needed, they issue debt. Equity issuance is the last resort. This order arises from asymmetric information: managers know the firm's true value better than outside investors. Issuing equity can signal that the firm is overvalued, so investors demand a discount. To avoid this cost, firms prefer internal financing and then debt, which is less sensitive to information problems. The theory explains why many profitable firms use little debt and why firms tend to issue debt after profits fall.
12. How does a stable dividend policy differ from a constant payout ratio policy?
A stable dividend policy keeps the dividend per share constant from year to year, while a constant payout ratio policy pays a fixed percentage of earnings each year. With stable policy, the dividend amount is steady, but the payout ratio (dividend/earnings) fluctuates as earnings change. With constant payout, the dividend goes up and down with earnings, so the amount varies, but the ratio is fixed. For example, if earnings drop, stable policy keeps dividend same, but constant payout would cut dividend. Stable policy is more common because it reduces uncertainty for investors. Constant payout can cause volatile dividends, which many investors dislike.