Capital Structure Flashcards
What is the capital structure of a company?
It refers to the mix of debt and equity used to finance a company’s assets and operations.
What is the M&M proposition without taxes and without bankruptcy costs?
1) cost of debt<cost of equity and WACC decrease.
2) leverage increase which increases the cost of equity and increases WACC.
The 2 effects are canceling each other and WACC stays constant
What is the M&M proposition with taxes and without bankruptcy cost?
The same 2 effects of the first proposition are presented. but a third effect is added.
The debt is exonerated of taxes which is beneficial for the capital structure and then the WACC decrease.
What is theoretically the optimal capital structure under the second proposition of M&M?
The company should be financed 100% by debt since it has no bankruptcy cost.
What is the name of the M&M proposition with taxes and bankruptcy costs?
The static trade-off theory.
What is the static trade-off theory?
The 3 effects of the last 2 propositions are still present.
A new effect is added:
Leverage increases, so financial distress is increasing, and the investor requirements are higher, which augments the WACC.
The optimal capital structure is a point balanced where debt and equity are in balance.
How do you find the company’s target capital structure of a company if it is not known?
1) You need to assume the company’s current capital structure using market value weights.
2) Examine trends in the company’s capital structure.
3) Use averages of comparable companies.
What are the factors affecting capital structure decisions?
- Capital structure policies and target capital structure.
- Financial capital investments,
- Market conditions.
- Information asymetries and signaling.
In which companies is asymmetric information relatively higher?
- Complex products.
- Less transparency in financial accounting information.
- Lower levels of institutional ownership.
What does the pecking order theory say?
It asserts that managers prefer modes of financing that offer the least information content to company outsiders.
What are examples of positive and negative signals by managers?
- Negative signal: issuance of new equity.
- Positive signal: issuance of more debt.
What are agency costs?
They refer to the costs arising from conflicts of interest when management decides for shareholders.
What costs are included in the agency cost? Describe them.
- Monitoring costs: costs incurred by shareholders to monitor the actions of management.
- Bonding costs: costs incurred by management to assure shareholders that they are working in shareholder interest.
- Residual loss: losses that refer to costs that are incurred despite adequate monitoring and bonding provisions.
What does Jensen’s FCF hypothesis tell us?
It tells that higher debt levels limit opportunities for management to misuse cash.
What is the value of the leveraged firm under proposition 1 of M&M without and with taxes?
What is the cost of equity of a firm under proposition 2 of M&M without and with taxes?
What is the value of the leveraged firm under the static trade-off theory?
