*Question 1.3: Debt-to-Equity Ratio
A major cost of bankruptcy is the expected loss in asset value upon dissolution of the firm.
Assets that can be sold without losing value have little cost of bankruptcy.
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The assets of pharmaceutical firms are past research and development, patents fornew medications, and the scientific knowledge of their staffs. These assets lose value
in bankruptcy, so the cost of bankruptcy is high.
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The assets of hotels are buildings in major cities and resorts. These assets do not losevalue in bankruptcy, so the cost of bankruptcy is low.
Suppose that hotels and pharmaceutical firms have the same expected return on assets
at their optimal debt-to-equity ratios and both types of firms have higher returns on equity
than returns on debt. Assume that the optimal capital structure depends on the cost of
bankruptcy, and both hotels and pharmaceutical firms are at their optimal capital
structures. We infer that
A. Hotels have higher debt-to-equity ratios and higher costs of equity capital.
B. Hotels have higher debt-to-equity ratios and lower costs of equity capital.
C. Hotels have lower debt-to-equity ratios and higher costs of equity capital.
D. Hotels have lower debt-to-equity ratios and lower costs of equity capital.
E. Hotels have lower debt-to-equity ratios and the same costs of equity capital.
Answer 1.3: A