capital structure Flashcards
what does the M&M model theorise and what were the limitations
they created an artificially simple word with limitations applied in order to come up with a workable theory
- All parties can borrow and lend at the same (risk free) rate of interest
- There are no transaction costs (including no costs of financial distress)
- There is no information asymmetry – homogeneous information (everybody knows everything)
- Investors are rational and risk-averse
- There are no taxes
what are M&M two propositions
- firm value (V) is not affected by leverage
VL = VU
2.leverage increases shareholders risk & return
rE = rU + (rU - rD) . (D/E)
rD = interest rate (cost of debt)
rE = return on (levered) equity (cost of equity)
rU = return on unlevered equity (cost of capital)
D = market value of debt
E = market value of levered equity
what was M&M next model
the corporate tax model, which relaxed the assumption of no taxes
are interest cost and dividends tax-deductible
interest costs are
dividends aren’t
how did M&M propositions change which corporate taxes
- Firm value increases with leverage (D). For permanent debt
VL = Vu + TcD - some of the increase in equity risk and return is offset by interest tax shield –> ie rE is not as high as when unlevered )
what is business risk vs financial risk
Business risk
The uncertainty in cash flows due to operating circumstances, e.g. related to production, market, competition, government policy, fluctuations in economic activity, financial shocks, pandemics etc.
Financial risk
The risk of not being able to repay the debt and entering bankruptcy
how does leverage affect cash flow and M&M corporate tax model
- leverage makes underlying cash flows more volatile
- for M&M leverage increased cost of equity but tax shield migrates risk to an extent
financial distress vs bankruptcy (static trade off theory)
a firm in financial distress does not necessarily go bankrupt
risk of financial distress vs costs of financial distress
The possibility of bankruptcy may have a negative effect on the value of the firm
However, it is not the risk of financial distress itself that lowers value
Rather it is the costs associated with being in financial distress that have an impact on value
what are financial distress costs
direct costs
- Legal and administrative costs (tend to be a small percentage of firm value)
Indirect Costs
- Impaired ability to conduct business (e.g., lost sales)
- Assets at liquidation only worth ‘fire sale’ prices
- Loss of key employees, difficult to recruit
- Suppliers more cautious, less favourable terms
- Lenders require a higher return
- Discounted sales of goods and services
what is pecking order theory
Pecking order theory starts with the relaxation of the homogeneous information assumption – to allow for asymmetric information (insiders know more than outsiders)
Pecking order:
1. Firms prefer internal financing (‘financial slack’)
2. They prefer debt if internal financing isn’t sufficient
3. Firms will issue safe debt first, then move to hybrids such as convertible debt
4. External equity is a last resort
what does pecking order theory predict
There is no optimal debt ratio – it depends on the need for financing at a point in time
Equity is at the top (internal financial slack) and the bottom of the pecking order (external equity)
Firm will use external financing when there is insufficient financial slack
Debt requires less scrutiny than equity issues
With equity and asymmetric information - the market knows that firm will only issue equity if managers feel it is over-valued
what is market timing theory
this theory argues that managers of companies are trying to do what many investors also try to do – time the market
Manager tries to spot the ‘right’ timing of equity financing
Firms are more likely to issue equity when their market values are high relative to book values and past market values, and to repurchase equity when their market values are low
Current capital structure is strongly related to historical market values. The results suggest that capital structure is the cumulative outcome of past attempts to time the equity market
what does the free cash flow hypothesis say
an increase in dividends should benefit that shareholders by reducing the ability of managers to pursue wasteful activities
it also argues that an increase in debt will reduce the ability of managers to pursue wasteful activities more effectively than dividend increases
what did stakeholder theory find
- firms that value employees firm specific human capital maintain low debt ratios
- highly leveraged companies are more likely to lay off employees
- employees therefore avoid highly leveraged companies
- ## companies with unique products must maintain financial stability to attract customers and suppliers hence likely to have lower leverage
