Chapter 13: Capital Structure: Nontax Determinants ofCorporate LeverageAnswers to End of Chapter QuestionsSolutions to End of Chapter ProblemsOption 2Capital Structure: Nontax Determinants of Corporate Leverage 141Chapter 13: Capital Structure: Nontax Determinants ofCorporate LeverageAnswers to End of Chapter Questions13.1. The primary non-tax factors that influence capital structure are bankruptcy and agency costs andtiming – whether the stock price is high or low. Firms facing higher bankruptcy and agencycosts tend to have less debt in their capital structures. The effects of timing – issuing new eq-uity when the stock’s price is high – can have lasting impacts on firms’ capital structures.13.2. Firms with higher bankruptcy costs (higher risk firms) tend to have less debt in their capitalstructures. The lower level of debt reduces their overall risk. Firms with higher agency coststend to have more debt in their capital structures. The higher level of debt tends to forcemanagers to work harder to maximize value and keeps managers from mis-spending firmearnings. Firms do take advantage of timing – issuing stock when the market is high and debtwhen interest rates are low. The following factors negatively impact firms’ debt levels: prof -itability, market to book ratios, earnings volatility, non-debt tax shields, managerial entrench-ment, personal tax rate on equity income, and creditor power in bankruptcy. Factors that gen-erally meant more debt in a firm’s capital structure included: degree of regulation, size, assettangibility, corporate income tax rate and state ownership.13.3. Limited liability is shareholders’ valuable default option. Shareholders have the right to walkaway from a failed firm. The most that they can lose is their investment in the firm. Credi -tors cannot claim shareholders’ personal assets. In the event of bankruptcy, creditors must besatisfied with the value of the firm as their payment, even if that value is less than the facevalue of their original debt. The more a firm borrows, the less equity financing it requires.With a relatively low investment in the firm, the default option becomes quite valuable. If afirm invests in a risky project that turns out well, shareholders may enjoy a large positivegain. But if the project fails, shareholders only lose their original investment in the firm.13.4. A software development firm would face higher costs of financial distress than the hotel chain.The main asset of the software development firm is the expertise of its programmers, an in -tangible asset. The hotel chain’s assets are its hotel properties. A lender can repossess andsell physical assets like hotels; it cannot repossess and sell human capital. In distress, thesoftware company’s programmers may jump ship and move to another, healthier softwarebusiness, and the firm will lose even more in value as its human assets leave.13.5. Managers of financially distressed firms will have incentive to gamble with bondholders’money. If little value will accrue to shareholders in the event of a liquidation, management,while still in control of the distressed company, may invest in highly risky projects (asset sub-stitution) that have a small probability of a large payoff and a high probability of a zero orlow payoff. This may give shareholders a small probability of increasing their wealth at theexpense of bondholders. Shareholders also have little to no incentive to invest more equityinto a failing company. Management may pass up good, positive net present value projects iftheir only source of funding is new equity financing.142 Chapter 1313.6. Indirect costs of bankruptcy are considered to be higher than direct costs. Direct costs includemanagement time, legal fees, and court costs. Indirect costs include loss of firm value be-cause of actions taken by the bankruptcy judge, management, customers or suppliers. For ex-ample, if the firm sells a product where a long-term warranty is important, customers mayabandon the firm because they are afraid they will be unable to obtain future service on theirproduct. Suppliers might refuse to supply the firm on reasonable terms, making it impossibleto continue business. Managers or judges may make poor business decisions, for example,continuing a money-losing business model after it should have been shut down.13.7. Empirical studies have confirmed that indirect bankruptcy costs may be very high. Firms enter-ing bankruptcy have lower sales in the years after filing than they were expected to havebased on prebankruptcy growth rates. This supports the conjectures that customers may bereluctant to deal with a failing firm. Managers of bankrupt firms lose their jobs more fre-quently than do managers of nonbankrupt firms, and their pay decreases dramatically. U.S.courts frequently deviate from absolute priority rules. Bankruptcy costs are higher in theU.S., where the legal system tends to favor managers over creditors, than in other developedcountries. Bankruptcy reduces a firm’s debt levels less than might be expected, leaving manyfirms vulnerable to reentering bankruptcy at a later date. Firms facing higher bankruptcy riskhave less debt in their capital structures. Companies with highly variable earnings use lessdebt; leverage ratios across industries are related to a company’s investment opportunities;and capital intensive industries with few growth options tend to be highly levered, while tech-nology-based industries with many growth options have relatively little debt. In addition,leverage ratios appear to be directly related to how easily a firm’s assets can pass throughbankruptcy without losing value.13.8. In general, U.S. bankruptcy laws tend to favor managers over creditors. The old managementremains in control and the company’s plan tends to have priority during a reorganization.Most other Western countries strike a more even balance between creditor and debtor inbankruptcy. Creditors in these countries have less concern that managers may expropriatetheir wealth during financial distress. Creditors will be more willing to lend money at attrac-tive rates. Corporate managers in other countries have more reason to fear financial distress,since they are more likely to be quickly fired and replaced with a trustee. This should en-courage non-U.S. firms to use less debt financing than managers of similar U.S. companies.13.9.