Capital Structure- Question 16 + 18 reading 20

Question 16- Why is answer B and not A? By issuing debt, isn’t the company lowering its bonding costs? How can we infer from the share buyback the impact it will have on the percentage of the tangible assets and operating leverage?

Question 18- why does Garth have more business risk?

Think you misunderstood the question. What the question is asking to pick from one of the notes made by White that does not support the conclusion that Bema’s total market value will decline relative to Aquarius.

  • A. Bema’s bonding costs will be higher than Aquarius’s

IF THIS IS TRUE, then Bema will have a higher cost of equity relative to Aquarius, hence Bema’s total market value should be lower relative to Aquarius :arrow_right: so this is a consistent with the conclusion made by White. (Note that bonding costs is an agency cost of equity and is the cost borne by management to assure shareholders that the management will act in the best interest of shareholders, e.g. signing non-compete agreements).

  • B. Bema will have a lower degree of operating leverage than does Aquarius.

IF THIS IS TRUE, then Bema will have lower business risk, hence lower cost of equity, so the total market value of Bema should be higher than Aquarius :arrow_right: so this is inconsistent with the conclusion made by White.