Limits to the Use of Debt
10 important questions on Limits to the Use of Debt
What are the 3 debt constraint theories?
2. The pecking order theory
3. The market timing theory
What is the tradeoff theory?
What are the benefits of debt?
2. Limit to discretionary expenses by management (reduction of agency costs)
3. Banks monitor the expenses of management to protect their interests (reduction of agency costs)
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What are the costs of debt?
2. Agency costs such as underinvestment or more incentives to choose high risk projects
3. Personal taxes on interest income
What are the 2 types of agency costs?
2. Agency costs of equity - other costs
In what ways can managers increase the value of equity at the expense of debt?
2. Underinvestment (investing too little in a certain project)
3. Milking the property: paying out extra dividends in a situation of financial distress, which leaves less money for creditors in case of bankruptcy
What are the 3 agency costs of equity?
2. Perquisites (costs incurred when managers give more luxury to themselves than is reasonable)
3. Bad investments (investments that increase own salary but decrease return for shareholders)
What is the pecking order theory?
What is the pecking order hierarchy?
2. Use debt
3. Use equity
What is the market timing theory?
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