Suppose changes in corporate law make it more difficult for debt holders to force companies into bankruptcies. This will cause firms to:
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A. B. C. D.B
It is tempting to assume that lower probability of bankruptcy will entice firms into borrowing more. However, remember that debt holders are not entirely stupid!
They will factor in this change in the law and demand a higher yield and stricter covenants on corporate debt to compensate for the lower recourse they have against the firms. Depending on whether they actually underestimate or overestimate the effect and also depending on whether the firms perceive that the debt holders have under- or overestimated the effect, companies could increase or decrease their debt levels.