Which of the following are not examples of a vicious cycle of deleveraging? Explain.
a. Your university decides to sell several commercial buildings in the middle of town in order to upgrade buildings on campus.
b. A company decides to sell its large an valuable art collection because other asset prices on its balance sheet have fallen below a critical level, forcing creditors to call in their loans to the company because of provisions written into the original loan contract.
c. A company decides to issue more stock in orders t voluntarily pay off some of its debt.
d. A shadow bank must sell its holdings of corporate bonds because falling asset prices have led to a default on the terms of its loan with some creditors.
Deleveraging is defined as attempts made by a company to release the burden of debt to protect them from the risk of default. In this process, firms try to reduce the debts accumulated before without creating any debt.
Answer and Explanation:
1) The statements given in the options a and c are not an example of the vicious cycle of deleveraging. It is because the university is voluntarily selling its commercial buildings to upgrade its campus. In the other statement c, the company is voluntarily selling its stock to pay off some of its debt.
2) The statements given in the options b and d are an example of a vicious cycle of deleveraging. It is because if the company decides to sell a large volume of valuable art in the market to obey the loan contract, then it will negatively impact the prices of such valuable art pieces elsewhere as the individuals can get it at low prices. In this case, valuables are sold to free themselves from the burden of debt. In the statement d banks are selling corporate bonds to save themselves from the risk of default.
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from Financial Accounting: Help and ReviewChapter 8 / Lesson 7