Capital structure

Question 1

Capital structure essay plan

Answer 1

-Define
-Tax benefits for debt
-Bankruptcy costs/financial distress
-Implications and predictions of
model.

Question 2

What is capital structure

Answer 2

The way a company finances its overall operations and growth. Using different sources of funds.

Question 3

Sources of funds

Answer 3

Debt and equity, expressed as a ratio to each other D/E ratio. Draw pie chart.

Question 4

Debtholders

Answer 4

Also known as creditors. Lend money in exchange for interest and or principle repayment.

Question 5

Equity holders

Answer 5

Contribute funds through purchasing shares and allowing earnings to be retained. Paid last in bankruptcy

Question 6

High vs low level of debt

Answer 6

High debt can increase financial risk.
Low debt may limit growth opportunities.

Question 7

Debt and equity pie chart

Answer 7

See notes. How a company is split in terms of debt and equity.

Question 8

Tax benefits of debt

Answer 8

Interest payments are tax deductible whereas dividends are not.

Question 9

How are interest payments deductable?

Answer 9

Considered a business expense and are deductible. Therefore lower the taxes payable by a company. Tax interest shield.

Question 10

Income statement differences

Answer 10

Show numerical example. After tax cost of debt is reduced due to the tax deductibility.

Question 11

Corporate level vs personal

Answer 11

At a corporate level debt offers tax benefits however equity financing may be better at a personal level

Question 12

Bankruptcy

Answer 12

Bankruptcy occurs when asset value is insufficient to pay debt.

Question 13

Bankruptcy costs

Answer 13

Direct
Indirect
Loss of asset value
Disruption for business prior

Question 14

Direct costs

Answer 14

Legal and admin costs expected at 1-3% for US bankruptcies. Larger for smaller businesses

Question 15

Legal and admin costs

Answer 15

-Negotiating with debtholders
-Resolving disputes between different
debtors
-Trial costs (expert witnesses etc)

Question 16

Agency costs

Answer 16

Internal costs due to the competition between bondholders and shareholders

Question 17

Indirect costs

Answer 17

Loss of asset value
Business is harder to conduct.
Davydenko et al (2012) finds 30% of a firms value disappears in bankruptcy.

Question 18

Loss of asset value

Answer 18

Asset value is easily lost if the assets are intangible e.g brand rep.
Presence of secondary market for firm’s other assets.

Question 19

Why is business harder to conduct?

Answer 19

Suppliers, customer, employees, investors, etc. all will lose faith in the business. Employees may leave. Suppliers may stop supplying without immediate payment etc.

Question 20

Trade off model

Answer 20

Diagram in notes. Be able to draw it.
Firms will have a ‘target’ debt ratio.

Question 21

Predictions from trade off model

Answer 21

Leverage increases
Leverage decreases

Question 22

Leverage increases

Answer 22

Leverage increases with taxable profit, asset tangibility, firm size.

Question 23

Leverage decreases

Answer 23

Leverage decreases with growth opportunities, volatility of operating cash flows, non-debt tax shields.

Question 24

When do changes in capital structure benefit shareholders

Answer 24

Only if the value of the firm increases. Managers choose capital structure with highest firm structure

Question 25

MM proposition 1 (no taxes)

Answer 25

The value of a levered firm is the same as the value of an unlevered firm.

Question 26

Assumptions of MM 1

Answer 26

Individuals can borrow as cheaply as corporations.
There are no taxes.
No transaction costs

Question 27

MM proposition 2

Answer 27

The cost of equity rises with leverage because the risk to equity rises with leverage.