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1 Because the weighted average given in Equation(17.4) is always a correct measure of a required return, why do firmsnot create securities to finance each project and offer them in thecapital market in order to accurately determine the required return for the project?
Firms cannot offer new securities for each project to determine the required return because of transaction costs and costs associated with asymmetric information. Transaction costs as a percentage of the issue are lower for larger issues. Firms must issue securities in bulk to take advantage of economies of scale in financing. Also, firms face an asymmetric information problem in that outside investors, especially equity, may need to be enticed to invest with a discount for the new shares. Issuing securities for each project would be too expensive.
2 The development of the new issue junk bond market had important implications for capital structure choice. Theexistence of a viable junk bond market means that firms can comfortablymaintain higher degrees of leverage than they could prior to thedevelopment of this market. Do you agree or disagree? Justify youranswer.
An active junk bond market does have implications on the capital structure decision. Firms with debt ratings below investment grade are still capable of raising debt capital, allowing firms to increase their leverage without the fear of being denied access to future debt capital. However, the implications are minimal as the interest rate demanded by junk bond investors is high, making risky debt expensive.
3 Suppose that your firm is operating in a segmented capital market. What actions would you recommend to mitigate the negative effects?
The best solution for this problem is to cross-list your firm’s stock in overseas markets like London and New York that are not segmented. But you should be aware of the associated costs such as the cost of adjusting financial statements, fees charged by the listing exchanges, etc.