Capital structure Flashcards
what does the capital asset pricing model provide a formula for/
calculates the expected return on a security based on its level of risk
what is the CAPM formula?
risk free rate + beta x (return on market - risk free rate)
is equity or debt the more expensive type of capital?
equity
describe Modigliani and Miller capital structure theory - with tax
argued that the value of the company is not decided by financing decisions , is determined by investment decisions
‘the total market value of any company is independent of its capital structure’
firms should borrow as much as possible as the tax shield makes debt cheap
describe Modigliani and Miller capital structure theory - without tax
shareholders and forms have acces to the same levels of interest on loans and deposits
no taxation
perfect capital markets
companies pay-out all distributable earnings as dividends
describe the trade-off model
balancing the cost vs benefits of debt to achieve an optimum capital structure
describe the pecking order theory
Suggests there is no optimal capital structure
Firms operate in the presence of information asymmetry
Managers choose how to raise additional capital according to the following pecking order:
Using internal fund if possible: cheaper to raise, readily available and avoid sending adverse signal to the market
If internal fund is not available, debt is preferred to equity but equity issues are often interpreted as more adverse signals as it could be a sign that the managers believe the firm’s shares are overvalued
describe the hidden costs of debt
Uncertainty as to no long term survival – affects customers, staff and suppliers
Cash restrictions – sub-optimal stock levels, excessive attention to short term liquidity
Agency costs – increased management constraints
Bankruptcy costs
which factors do affect a firms level of debt?
Borrowing capacity
Managerial preferences
Marketing timing
Financial slack
Signaling
Control vs new shareholders
Tax exhaustion
Industry group gearing – industry norms
Previous policies – clientele
Perception of fund raising/paybacks
