20.6: Other Factors Affecting Capital Structure

Question 1

Define the static trade-off theory and explain its importance in capital structure decisions.

Answer 1

Static Trade-Off Theory

• Definition: A theory that states a firm uses debt to maximize its tax advantages up to the point where these benefits are outweighed by the associated estimated costs of financial distress and bankruptcy.
• Importance:
  
  • Balances the tax shield benefits of debt with the potential costs of financial distress.
  • Helps in determining the optimal level of debt in a firm’s capital structure.
  • Illustrated by the relationship between firm value, debt ratio, and financial distress costs.

Question 2

Figure 21.8: Firm Value and Financial Distress Costs

Answer 2

Figure 21.8: Firm Value and Financial Distress Costs
- Straight Line: Represents the M&M value of the levered firm, factoring in corporate taxes (Value = Unlevered Firm Value + Tax Shield).
- Curved Line: Shows expected value loss from financial distress and bankruptcy, increasing with the debt ratio.
- Optimal Debt Level: Occurs where the slope of the tax-corrected value line equals the slope of the financial distress curve, balancing tax benefits against distress costs.

Question 3

Explain how the WACC is affected by debt according to the static trade-off model.

Answer 3

WACC and Debt

• Initial Impact: WACC declines as more debt is added due to the cheaper cost of debt.
• Beyond Optimal Point: WACC begins to increase when financial distress and bankruptcy risks outweigh tax benefits.
• D/E* Point: The debt-to-equity ratio where WACC is minimized and firm value is maximized, representing the optimal capital structure.

Question 4

What is the pecking order theory, and how does it relate to capital structure decisions?

Answer 4

Pecking Order Theory

• Definition: The order in which firms prefer to raise financing, starting with internal cash flow, then debt, and finally common equity.
• Relevance:
  • Highlights the importance of information asymmetries and agency problems.
  • Suggests firms avoid issuing new equity to prevent adverse market reactions and maintain control.
  • Managers prefer financing methods that require the least external validation.

Question 5

Describe the impact of information asymmetries and agency problems on capital structure decisions.

Answer 5

Information Asymmetries and Agency Problems

• Information Asymmetry: Differences in information among shareholders, creditors, and management can lead to mispricing of new share issues and suboptimal capital structure decisions.
• Agency Problems: Managers may make decisions in their interest rather than shareholders, affecting the firm’s financing hierarchy.
• Effect: Drives firms to follow a pecking order, prioritizing internal financing over external to avoid revealing sensitive information.

Question 6

Role in Pecking Order Theory

Answer 6

Role in Pecking Order Theory

• Information Asymmetries: Firms prefer internal financing to avoid signaling undervaluation and triggering negative market reactions.
• Agency Problems: Managers favor financing methods that align with their long-term commitments to the firm, often prioritizing internal cash flow.
• Result: Pecking order minimizes risk and justifications needed from managers, preserving firm value.