Capital Structure

Question 1

Sources of Funds

Answer 1

1) Equity
2) Debt

Question 2

Equity

What is it / does it offer?

Answer 2

Offers a residual claim on the CF and comes with much greater role in the operation of the business

Question 3

Debt

What is it / does it offer?

Answer 3

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

Question 4

Properties of debt claim

Answer 4

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

Question 5

Properties of equity claim

Answer 5

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)

Question 6

Classifying a security as debt or equity

Answer 6

Whenever a security is tax-deductible it can be classified as debt.

Question 7

Equity financing accord. to firm growth

Answer 7

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)

Question 8

Debt financing accord. to firm growth

Answer 8

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

Question 9

Hybrid securities

Answer 9

Securities that have features of both equity and debt at the same time

Question 10

Preferred stock

Debt-like & equity-like features

Answer 10

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

Question 11

Convertible bond

Answer 11

Can be converted into a permited number of shares, at the discretion of the bondholder

Question 12

Contingent convertibles (CoCo)

Answer 12

Bonds converting into equity if a certain contidion is met

Question 13

Internal funding

(Advantages/Disadvantages)

Answer 13

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)

Question 14

Disciplining factor of debt

Answer 14

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)

Question 15

Tax benefit / tax shield

Answer 15

• 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

Question 16

Economic distress

Answer 16

The business is not doing well –> often difficult to distinguish at what point exactly economic distress can be determined for a business

Question 17

Financial distress

Answer 17

• Insufficient cash and liquid assets to meet current debt payments
• Violation of debt covenants

Question 18

Insolvency

Answer 18

Face value of liabilities exceed market value of assets –> firms in financial distress may or may not be insolvent

Question 19

Bankruptcy

Answer 19

Firms in insolvency can go bankrupt –> legal process of winding down a business, i.e. entering and conducting the liquidation process

Question 20

Bankruptcy cost formula

Answer 20

Bankruptcy cost = Probability of bankruptcy * (direct costs + indirect costs)

Question 21

Bankruptcy probability

Effects

Answer 21

Decreasing in size of operating CF
Increasing in the operating CF volatility
Increasing in borrowing levels

Question 22

Direct bankruptcy costs

Answer 22

• 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

Question 23

Indirect bankruptcy costs

Answer 23

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.

Question 24

Options to reduce financial distress

Answer 24

• 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)

Question 25

Advantages of debt

Answer 25

• Tax benefit: the higher the taxes the higher the benefit
• Added discipline: if increased separation between managers and equity holders, large benefit

Question 26

Disadvantages of debt

Answer 26

• 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

Question 27

Assumptions of perfect capital markets

Answer 27

• no taxes
• no transaction/issuance costs
• no agency cost
• no costs of bankruptcy

Question 28

MM Proposition I

Answer 28

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

Question 29

MM Proposition II

Answer 29

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.