Reference no: EM131560831

What theory do these belong too ? What theory do these best describe?

1. When there is leverage, a conflict of interest exists if investment decisions have different consequences for the value of equity and the value of debt. Such a conflict is most likely to occur when the risk of financial distress is high. In some circumstances, managers may take actions that benefit shareholders but harm the firm’s creditors and lower the total value of the firm. This means that when firms are highly levered up, they face very high cost of debt, enough to compensate the creditor’s agency costs.

2. Actual corporate leverage ratios typically do not reflect capital structure targets, but rather the widely observed corporate practice of financing new investments with internal funds when possible and issuing debt rather than equity if external funds are required. In this capital structure theory, an equity offering is typically regarded as a very expensive last resort.

3.Although the direct expenses associated with the bankruptcy process appear small in relation to market values, the indirect costs can be substantial. For many companies, the most important indirect cost is the loss in value that results from cutbacks in promising investment when the firm gets into financial trouble.

4. As the level of debt increases, the value of the firm increases from the interest tax shield (TC xD) as well as improvements in managerial incentives. If leverage is too high, however, the present value of financial distress costs, as well as the agency costs from debt holder–equity holder conflicts, dominates and reduces firm value. The optimal level of debt, D*, balances these benefits and costs of leverage.