Capital structure Flashcards
Capital structure essay plan
-Define
-Tax benefits for debt
-Bankruptcy costs/financial distress
-Implications and predictions of
model.
What is capital structure
The way a company finances its overall operations and growth. Using different sources of funds.
Sources of funds
Debt and equity, expressed as a ratio to each other D/E ratio. Draw pie chart.
Debtholders
Also known as creditors. Lend money in exchange for interest and or principle repayment.
Equity holders
Contribute funds through purchasing shares and allowing earnings to be retained. Paid last in bankruptcy
High vs low level of debt
High debt can increase financial risk.
Low debt may limit growth opportunities.
Debt and equity pie chart
See notes. How a company is split in terms of debt and equity.
Tax benefits of debt
Interest payments are tax deductible whereas dividends are not.
How are interest payments deductable?
Considered a business expense and are deductible. Therefore lower the taxes payable by a company. Tax interest shield.
Income statement differences
Show numerical example. After tax cost of debt is reduced due to the tax deductibility.
Corporate level vs personal
At a corporate level debt offers tax benefits however equity financing may be better at a personal level
Bankruptcy
Bankruptcy occurs when asset value is insufficient to pay debt.
Bankruptcy costs
Direct
Indirect
Loss of asset value
Disruption for business prior
Direct costs
Legal and admin costs expected at 1-3% for US bankruptcies. Larger for smaller businesses
Legal and admin costs
-Negotiating with debtholders
-Resolving disputes between different
debtors
-Trial costs (expert witnesses etc)
Agency costs
Internal costs due to the competition between bondholders and shareholders
Indirect costs
Loss of asset value
Business is harder to conduct.
Davydenko et al (2012) finds 30% of a firms value disappears in bankruptcy.
Loss of asset value
Asset value is easily lost if the assets are intangible e.g brand rep.
Presence of secondary market for firm’s other assets.
Why is business harder to conduct?
Suppliers, customer, employees, investors, etc. all will lose faith in the business. Employees may leave. Suppliers may stop supplying without immediate payment etc.
Trade off model
Diagram in notes. Be able to draw it.
Firms will have a ‘target’ debt ratio.
Predictions from trade off model
Leverage increases
Leverage decreases
Leverage increases
Leverage increases with taxable profit, asset tangibility, firm size.
Leverage decreases
Leverage decreases with growth opportunities, volatility of operating cash flows, non-debt tax shields.
When do changes in capital structure benefit shareholders
Only if the value of the firm increases. Managers choose capital structure with highest firm structure
MM proposition 1 (no taxes)
The value of a levered firm is the same as the value of an unlevered firm.
Assumptions of MM 1
Individuals can borrow as cheaply as corporations.
There are no taxes.
No transaction costs
MM proposition 2
The cost of equity rises with leverage because the risk to equity rises with leverage.
