Capital Structure Flashcards
Sources of Funds
1) Equity
2) Debt
Equity
What is it / does it offer?
Offers a residual claim on the CF and comes with much greater role in the operation of the business
Debt
What is it / does it offer?
Raise funds from investors or financial institutions by promising investors a prioritized, fixed claim (interest payments) on the CF generated by the assets, with limited or no operational role
Properties of debt claim
Static CF: contractual (interest & principal)
Priority: Debt comes first, periodical and liquidation CF are paid out first to debt holders
Tax: interest payments are tax deductible (creates tax-savings)
Maturity: fixed maturity date when principal is due
Control: debt investors have a passive role in the firm
Properties of equity claim
Dynamic CF: Entitles to any residual CF after meeting all other promised claims
Priority: Equity comes second, after satisfying fixed claims
Tax: equity flows (e.g. dividend payments) made from after-tax CF
Maturity: equity is perpetual –> infinite lifetime (expect if firm defaults)
Classifying a security as debt or equity
Whenever a security is tax-deductible it can be classified as debt.
Equity financing accord. to firm growth
1) Owner’s equity
2) Venture capital
3) Common stock
3.1) Company not listed yet (–> Initial public offering)
3.2) Listed company (at current market price)
Debt financing accord. to firm growth
1) Bank debt
1.1) One investor
1.2) No rating required
1.3) Flexibility (line of credit)
2) Bonds
2.1) Scalability (for large sums)
2.2) More favourable financing terms than equivalent bank debt
Hybrid securities
Securities that have features of both equity and debt at the same time
Preferred stock
Debt-like & equity-like features
Debt-like features:
(Mostly) fixed flow: if no cash, accumulated and paid at later stage –> cannot cause default
Limited control: no share of control & voting rights, only on what might affect their claims on the firm’s CF or assets
Equity-like features:
Tax: Payments to preferred stockholder are not tax deductible
Priority: Payments come out of after-tax CF
Maturity: No maturity date when the face value is due
Convertible bond
Can be converted into a permited number of shares, at the discretion of the bondholder
Contingent convertibles (CoCo)
Bonds converting into equity if a certain contidion is met
Internal funding
(Advantages/Disadvantages)
Advantages:
- External financing is not easy to raise for private firms
- High costs: issuing costs for equity are expensive
Disadvantages:
- May no suffice for all valuable projects
- Investors demand the same return on internal equity (i.e. retained earnings) and external equity (i.e. new stock adjusted for transaction/issuance costs)
Disciplining factor of debt
Assumes a conflict of interest between management and stockholders
Added discipline:
- FCF for project investments, equity paid outs (dividends, buy backs) or idle cash balances (buffer)
- Substantial FCF + no/low debt: management has a strong cash cushion against mistakes
- Borrowing creates a commitment (interest & principal) –> increasing the risk of default
- Inclusion of banks in the oversight process (by stockholders)
Tax benefit / tax shield
- Interest paid on debt is tax deductible
- Dividends are paid from after-tax CF
- Tax benefits increase with rising tax rates
> > > Taxes create a “tax shield” via deductible interest rates –> can be quantified
Economic distress
The business is not doing well –> often difficult to distinguish at what point exactly economic distress can be determined for a business
Financial distress
- Insufficient cash and liquid assets to meet current debt payments
- Violation of debt covenants
Insolvency
Face value of liabilities exceed market value of assets –> firms in financial distress may or may not be insolvent
Bankruptcy
Firms in insolvency can go bankrupt –> legal process of winding down a business, i.e. entering and conducting the liquidation process
Bankruptcy cost formula
Bankruptcy cost = Probability of bankruptcy * (direct costs + indirect costs)
Bankruptcy probability
Effects
Decreasing in size of operating CF
Increasing in the operating CF volatility
Increasing in borrowing levels
Direct bankruptcy costs
- Direct cash outflows
- Legal & administrative costs of winding down the business
Magnitude of costs depend on the business complexity and volume –> costs are estimated from 1.8% to 5% of the firm’s pre-bankruptcy value
Indirect bankruptcy costs
Costs that arise prior to the actual bankruptcy filing via market perception that a firm is in financial distress
- Customer: increased difficulty to sell products
- Operational suppliers: stricter terms to self-protect from client-default –> increased WC requirements/liquidity drains
- Financial suppliers: Difficulty to raise new capital for projects
Magnitude of indirect costs are difficult to estimate and largely depend on the product that the firm is providing.
Options to reduce financial distress
- Asset sales: rightsizing the balance sheet –> only if not insolvency/bankruptcy
- Merging with another firms: takes over your obligations
- Issue new securities: debt might not be an option/equity depends on equity holders
- Work it out: negotiations with creditors (extend debt maturity, forgive part of the loan, debt for equity swaps)
Advantages of debt
- Tax benefit: the higher the taxes the higher the benefit
- Added discipline: if increased separation between managers and equity holders, large benefit
Disadvantages of debt
- Bankruptcy costs: Higher business risk and bankruptcy costs, higher costs
- Agency cost: If increased separation between debt holders and equity holders, higher costs
- Loss of future financing flexibility: If increased uncertainty about future financing needs, higher costs
Assumptions of perfect capital markets
- no taxes
- no transaction/issuance costs
- no agency cost
- no costs of bankruptcy
MM Proposition I
In a world of perfect capital markets debt creates no benefits and has no costs.
»> The capital structure decision becomes irrelevant and has no impact on firm value
MM Proposition II
In a world of perfect capital markets a firm’s WACC is independent of its capital structure.
»> The cost of capital of levered equity increases with the firm’s market value debt-equity ratio.
