03 Financial Struckture

Question 1

What kinds of Equity are there?

Answer 1

• Common stock

- Preferred stock

Question 2

What kinds of Debt are there?

Answer 2

• Subordinated debt
• Ordinary debt
• Secured debt

Question 3

What are the Mezzanine finances

Answer 3

• Preferred Stock

- Subordinated Debt

Question 4

How is the MV Debt Ratio Calculated

Answer 4

V_D / (V_E + V_D)

Question 5

Which factors explain 27% of variation in market leverage

Answer 5

• Industry median leverage
• Tangibility
• Firm Size
• Market-to-book assets ratio
• Expected inflation

Question 6

What does the Modigliani Miller theorem state?

Answer 6

Capital structure is independent of firm value in perfect capital markets

Question 7

What are the assumptions of perfect capital markets?

Answer 7

• No taxes
• No cost of bankruptcy
• Perfect information
• No transaction cost for issuing debt and equity
• Investment decision not affected by capital structure

Question 8

What is the second proposition of Modigliani Miller theorem?

Answer 8

• Return on equity increases in proportion to leverage
• Risk increases too
  => Effect of increased ROEE and increased equity beta cancel

Question 9

How can you take tax effects into account?

Answer 9

Tax shield

V_L = V_U + T*D

Question 10

What other risk do high debts hold

Answer 10

financial distress

Question 11

What are the costs of financial distress?

Answer 11

Direct Costs:
Layers, accountants, consultants, …

Indirect Costs:
loss of business, additional working capital …

Question 12

What does the trade off theory state?

Answer 12

Optimal capital structure balances tax-shields against costs of financial distress

Question 13

What are the advantages of the trade off theory?

Answer 13

• Predicts moderate leverage
• Explains industry differences in capital structure
• Corresponds to management behavior

Question 14

What are the disadvantages of the trade off theory?

Answer 14

• Some successful companies have little debt
• Relation between tax-shield and value is not empirically evident
• Empirically, tax sensitivity of capital structure seems to be too low

Question 15

For what is FFO/Debt an indicator?

Answer 15

The Ability to repay debt form operating activities

Question 16

For what is Debt/EBITDA an indicator?

Answer 16

Leverage ratio

Question 17

For what is EBITDA/Interest expense an indicator?

Answer 17

The ability to pay interest expense

Question 18

For what is OCF/Debt an indicator?

Answer 18

Ability to repay debt form operating activities

Question 19

For what is FOCF/Debt an indicator?

Answer 19

Ability to repay debt from operating activities

Question 20

For what is DCF/Debt an indicator?

Answer 20

Ability to repay debt from operating activities after capex and dividend payments

Question 21

With which two violations of the Modigliani Miller Theorem does the Pecking-order theory deal?

Answer 21

• Asymmetric Information

- Transaction costs

Question 22

What does the lemon market theorem state

Answer 22

For types of available goods:
good, bad, new and old
Only owner knows true value
Good products will not be traded (only lemons)

Question 23

What does the pecking-order theory state

Answer 23

• Positive NPV projects are carried out if financed by retained earnings
• Positive NPV project will be carried out if financed by debt

Preference in financing sources

1. Retained earnings
2. Debit financing
3. External equity financing

Question 24

With wich violation of the Modigliani Miller Theorem does the Free Cash-Flow Theory deal?

Answer 24

Investment decision depends on the capital structure

Question 25

Why does excess cash lead to inefficiencies?

Answer 25

• Overinvestment (below cost of capital) -> empire building

- > Debt reduces cash and its financial obligation pressures managers

Question 26

What is the Agency problem

Answer 26

Managers can maximize their wealth at expense of shareholders

Question 27

What does the Free Cash Flow Theory State?

Answer 27

Optimal capital structure minimizes total agency costs

• Agency costs resulting from monitoring to prevent bondholder expropriation
• Agency costs of external equity resulting from monitoring managerial slack