CFA Level I · CFA Level I Exam · Capital Structure
Which action by a company's managers would most likely be interpreted by investors as a credible positive signal about future prospects?
Raising debt with higher fixed interest payments is the most credible positive signal. Managers of weaker firms would avoid it because of the greater risk of financial distress, so taking it on shows confidence in future cash flows, whereas issuing equity is usually read as a sign of overvaluation.
- AIssuing new shares ahead of a planned acquisition
- BReplacing long-term debt with a larger equity issue
- CRaising debt that commits the firm to higher fixed interest paymentsCorrect
Explanation
Taking on fixed obligations is costly if cash flows disappoint, since it raises distress risk, so only managers confident of future cash flows would do so. This makes the signal credible. Equity issuance is generally read as negative news.
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