21.7 Capital Structure in Practice Flashcards
What is the pecking order in finance?
The order in which firms prefer to raise financing, starting with internal cash flow, then debt, and finally common equity.
Explain the concept of information asymmetry problems in finance.
Information asymmetry problems arise from the effect of informational differences among shareholders, creditors, and management, leading to inefficiencies in the market and decision-making processes.
What are agency problems and how do they affect capital structure decisions?
Agency problems occur when managers make decisions on behalf of shareholders but have their own interests at stake, potentially leading to decisions that do not align with shareholders’ best interests.
What is a pecking order and why might firms follow it?
A pecking order refers to the hierarchy firms follow in raising funds, preferring to use internal cash flow first, then debt, and issuing equity as a last resort.
This minimizes the risk and the need for external justification for financing decisions.
How does the pecking order relate to information asymmetries and agency problems?
The pecking order minimizes the need to divulge information or justify decisions, reducing the impacts of information asymmetries and agency problems by relying on internal financing and debt before equity.
What question should be asked to determine if a firm should use debt according to the static trade-off theory?
Is the firm profitable? If the firm has no profits, it can’t use the tax shields from debt.
What type of assets should a firm have to consider issuing debt?
The firm should have tangible assets that can be used as collateral for a secured loan.
What determines the riskiness of a firm’s underlying business?
The variability of the firm’s operations and its market environment contribute to the assessment of its underlying business risk.
Why might larger firms carry less risk compared to smaller firms?
Larger firms tend to have more diversified operations and greater market power, which generally results in less risk compared to smaller firms.
What is the relationship between a firm’s growth rate and its need for cash?
Growing firms need cash to support their expansion, while profitable firms typically generate enough cash internally, affecting their need for external financing.
When might a firm decide to issue common shares?
A firm might issue common shares if its share price is high and increasing, indicating that the stock may be overvalued and offering a good opportunity to raise capital.
What are the basic questions to determine a firm’s financing decisions according to the Deutsche Bank survey?
- Is the firm profitable?
- What type of assets does the firm have?
- How risky is the firm’s underlying business?
- How big is the firm?
- What is the firm’s growth rate and profitability?
How does credit rating impact a firm’s capital structure decisions?
Firms may take measures to maintain their credit rating, which can influence their decisions regarding the level of debt they carry.
How do survey results from Deutsche Bank indicate the presence of a target capital structure?
Survey results show that 90% of firms in Latin America and 85% in North America have a target capital structure, supporting the notion of an optimal capital structure balancing tax advantages and financial flexibility.
