1)

According to the agency theory of equity, the use of debt could lead to better disciplined management. This argument is built around the premise that stockholders generally have little power over managers. If this argument holds true, a company borrows more debt should

A) Invest more in good projects after the borrowing

B) Invest less in good projects after the borrowing

C) Invest more in bad projects after the borrowing

D) Invest less in bad projects after the borrowing

E) None of the above

1b)

A cost that has to be incorporated into the capital structure policy is the expected cost of bankruptcy. As the cost of bankruptcy rises, companies should borrow less money. Assume that you are looking at a British power company that has historically enjoyed monopoly power and has funded itself with a significant amount of debt. The electricity market has now been opened up to competition. What change would you expect to see in the companys debt policy?

1. A) None. The company will still be profitable

2. B) Debt/equity ratio should increase.

3. C) Debt/equity ratio should decrease.