XYZ Inc. announces plans to finance the expansion of the firm by issuing hundreds of millions of dollars of bonds. Discuss how the current stockholders of XYZ Inc. will feel about this plan.
What will be an ideal response?
The common stockholders may have mixed feelings about this announcement. On one hand, they may applaud the proposal because (as we saw in the chapter), the use of leverage by a firm can increase the expected return to equity, which are the stockholders. On the other hand, the stockholders are residual claimants, so the increased use of bonds means the company is required to honor its liabilities to the bondholders (interest payments) before any profits are distributed to the stockholders. If the expansion proves to be profitable it can certainly turn out to be a good decision for the stockholders who may see the higher return from leverage. On the other hand, if the company's estimate or forecast is wrong and the expansion does not prove profitable, the stockholders will see a lower return than they would have without the expansion. This reflects the trade-off presented by leverage discussed in the chapter. The expected return is increased but so is the standard deviation of that return (risk).
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If the money multiplier is 10, the sale of $1 billion of securities by the Fed on the open market causes a
A) $10 billion decrease in the money supply. B) $1 billion decrease in the money supply. C) $1 billion increase in the money supply. D) $10 billion increase in the money supply.
When interest rates go down, people are
a. more likely to borrow b. less likely to borrow c. does not affect a person's consumption d. None of the above
One complication that tends to prolong recessionary gaps is that wages
a. are fixed by unions, which represent nearly all workers in the United States. b. tend to rise rapidly. c. rarely fall. d. tend to move in the opposite direction from prices.
A consumer's preferences for $1 bills and $20 bills can be represented by indifference curves that are
a. bowed out from the origin. b. bowed in toward the origin. c. straight lines. d. right angles.