! The assets of pharmaceutical firms are past research and development, patents for

new medications, and the scientific knowledge of their staffs. These assets lose value

in bankruptcy, so the cost of bankruptcy is high.

! The assets of hotels are buildings in major cities and resorts. These assets do not lose

value 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

Can someone please explain why B is not correct?

[NEAS: Hotels have more debt with a low expected return but the same overall cost of capital, so their cost of equity capital is higher.]