Question

1. In hindsight, we learned that investment banks in the period 2007 to 2009 leveraged their balance sheets to high levels. Why did they do so? (2 points) Explain what happened to these investment banks through the prism of the theories of capital structure. (2 points)

(Answer the question in no more than 5 total sentences.)

2. For the purpose of determining capital impairment under Delaware General Corporation Law § 154 and § 160 and under Klang v. Smith’s Food & Drug Centers, Inc., why shouldn’t the determination of capital impairment be determined solely by the company’s financial statements and the pro forma financial statements giving effect to the distribution to shareholders?  

(Answer the question in no more than 5 total sentences.)

Answer 1

Investment banks overleveraged to increase their revenue and profitability. Please keep in mind that in financial sector, debt assumes different role than it does in regular sector. Investment banks also used their toxic assets to raise their productivity. From the view point of theories of capital structure, such overlevering increased the risk profile of the banks and made cost of capital higher. It also threatened the liquidity and sustainability of the bank when the debt went bad.