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2) U.S. public companies with “low” leverage have an interest-bearing net debt-to-equity ratio of 0 percent or less, firms with “medium” leverage have a ratio between 1 and 62 percent, and “high” leverage firms have a ratio of 63 percent or more. Given these data, how would you classify the following firms in terms of their optimal debt-to-equity ratio (high, medium or low)?

• A successful pharmaceutical company

• This will have a low debt to equity ratio because it has a high level of R&D, which makes it risky. Also since most assets such as patents, human capital, and R&D are intangibles, it is harder to be used as collaterals for loans

• An electric utility

• This will have a high debt to equity ratio because this type of companies usually has lower business risk as its earnings are not sensitive to economic fluctuations. It is also in favor of debt financing due to a large tangible assets to provide security for lenders.

• A manufacturer of consumer durables

• This will have a medium debt to equity ratio because of a mix of tangible and intangible assets that could be used for collaterals for debt financing. Also, it faces some competition and will be affected by economics fluctuation.

• A commercial bank

• This will have a high debt to equity ratio because it has insurance policy of the government and since it is a commercial bank, it has high liquidity.

• A start-up software company

• This will have a low debt to equity ratio because its main asset are intangible assets such as researching and development (R&D), which makes hard to use as collaterals for debt financing and it’s very risky.

6) Many debt agreements require borrowers to obtain the permission of the lender before undertaking a major acquisition or asset sale. Why would the lender want to include this type of restriction?

Debt agreements are meant to protect the lender from the possibility of increased business risk, by asking borrowers to obtain a permission of the lender before making a major acquisition. This is because company executives may want to invest or undertake a major acquisition during financial difficulty in order to increase stock price. However, these high risk investments or asset sale can decrease the value of debt. Also, asset sales also means a decrease in collaterals which decreases the security lenders have.