Book 2_Corp_Capital structure

Question 1

WACC

Answer 1

WACC = [weight of debt × pretax cost of debt × (1 − tax rate)] + (weight of equity × cost of equity)

Question 2

Internal factors that affect capital structures

Answer 2

• the characteristics of the business,
• the company’s existing debt level,
• their corporate tax rate,
• and the company’s life cycle stage

Question 3

External factors

Answer 3

Market and business cycle conditions

Question 4

A company’s ability to issue debt

Answer 4

• more stable, predictable, and recurring => more debt
  + predictable cash flows sufficient to make required debt payments
  + liquid tangible assets that the company can pledge as collateral for debt.

Question 5

Debt level of some company types

Answer 5

• New companies with few assets and negative or uncertain cash flows: little to no debt
• Growth companies with positive cash flows and decreasing business risk: Lower debt
• Mature companies with predictable cash flows: Significant more debt

Question 6

MM’s propositions with no taxes

Answer 6

a company’s capital structure is irrelevant
- its WACC and firm value are unchanged by changes in capital structure

Question 7

MM’s propositions with taxes but without costs of financial distress

Answer 7

a company’s WACC is minimized and its value is maximized with 100% debt financing.

Question 8

Static tradeoff theory

Answer 8

adds the expected costs of financial distress to the model
- firm value initially increases (and WACC decreases) with additional debt financing
- but that company value decreases at some point with additional debt as the increase in the expected costs of financial distress outweigh the increase in tax benefits from additional debt.

Question 9

Target capital structure

Answer 9

the capital structure that a firm seeks to achieve on average over time to maximize firm value

Question 10

Pecking order theory base

Answer 10

• based on information asymmetry between firm management and investors
• suggests that management’s choice of financing method signals their beliefs about firm value

Question 11

Pecking order theory

Answer 11

Managers prefer to make financing choices that are least likely to send negative signals to investors.
- retained earnings are the most preferred source of funds,
- followed by debt financing,
- and then issuing new equity.

Question 12

the free cash flow hypothesis

Answer 12

the agency costs of equity, which arise because management and shareholders may have conflicting interests, are reduced by increased debt issuance.