As the united states slid deeper into a recession, companies with high amounts of cash relative to their debt were coveted by the stock market, while companies with high levels of debt slashed dividends, payrolls and capital expenditures to stay afloat. High debt, combined with slower sales and increasing energy and labor costs, proved to be a deadly combination for a number of companies. Standard & Poor’s found that both dividend decreases and omissions were up. Defaults on corporate notes and bonds payable rose to a record level as companies missed debt payments. Moody’s investors service noted that at the time an average of only 41 percent an average of 67 percent of the face value, while holders of debentures recovered an average of only 23 percent.
Required:
(a) U.S. corporations have dramatically increased their debt levels in recent years. Discuss how high levels of debt may influence the way in which a company is managed. That is how might management concerns and decisions be different because a company is carrying a large amount of debt?
(b) Describe the financial statement effects of this borrowing activity, and explain how these effects could have helped investors and creditors to avoid the losses incurred during the recession. How and why might the reported levels of debt on the balance sheet be less than the actual levels of debt carried by the company?
(c) Define a debenture and explain why defaults on debentures would lead to a lower recovery rate for investors than defaults on secured bonds.