Which factors tend to cause companies’ D/E ratios to be potentially lower? A country has: I. Large institutional investors. II. Active bond and stock markets. III. Taxes that favor debt. IV. High inflation.
Probably IV.
Yeah. High inflation would mean bond investors would be worried to get stuck in fixed coupon payments, and therefore would be attracted to equity. The others probably favor higher debt levels: institutions like bonds, active markets mean there is no dis-incentive to investing in debt (i.e. liquidity discounts), and favorable taxes is straight-forward.
think about it another way: I. Large institutional investors. means they want more protection for their investments - which bond covenants provide. II. Active bond and stock markets. active bond markets tend to favor more debt investments - though active stock markets are also present - since cost of debt < cost of equity – debt would be good here. III. Taxes that favor debt. obviously debt would be favored to the max extent possible… so I, II and III tend to favor a bigger D/E ratio.
Correct Answer: I and IV.
I understand IV,but why I?
See below- decent explanation in the answer to this q-bank: Question ID#: 87225 -------------------------------------------------------------------------------- Financial leverage ratios tend to be to low in countries that have: A) a high reliance on the banking system for raising debt capital. B) inefficient legal systems. C) a large institutional investor presence. Your answer: C was correct! Firms operating in countries with an active, large institutional investor presence tend to have less financial leverage. Large institutional investors tend to have greater resources to analyze companies and reduce information asymmetries, which reduces the use of debt. By contrast, companies with weak legal systems and a high reliance on the banking system will all tend to have higher debt ratios.
thx guys…