Question 5: Capital Structure (20 marks)

1. Explain why new start-up firms have less agency costs than large public firms. (3 marks)

2. Why do young technology or biotechnology firms often have capital structures that do not include debt? (3 marks)

3. Financial distress costs increase in Australia. According to the trade-off theory of capital structure, what changes would you expect to see in Australian firms corporate structure? Justify your answer. (3 marks)

4. Give three reasons why on average firms have only used debt to shield less than 50% of their income from tax. (3 marks)

5. Explain why, according to the pecking order theory of capital structure, managers prefer to use debt rather than equity to fund investments. (2 marks)

6. Etrade Enterprises is currently an all-equity firm with an expected return of 16%. It is considering a leveraged recapitalisation in which it would borrow and repurchase existing shares. Assume perfect capital markets. Etrade borrows so that its debt to equity ratio is 0.4. The cost of debt is 7%. Calculate Etrades expected return on equity with its new leveraged capital structure. (6 marks)

(Please ensure that you show all working, you can insert a scan or photograph of handwritten workings if you wish).