Capital Structure Flashcards
Why will debt value sometimes increase in volatility?
Higher volatility will reduce the bankruptcy-point in terms of firm value. When the firm is close to bankruptcy, the dominating effect of a lower bankruptcy point will be increased debt value
In the Leland model, what happens to the coupons as the total value of the firm increases?
The coupons will increase proportionaly
In the Leland model, what happens to the debt as the total value of the firm increases?
The value of debt will increase proportionaly
In the Leland model, what is the effect of an increase in profitability on leverage?
Increasing profitability will increase the value of the total value of the firm. This will also increase the optimal coupon and the debt. However, these effects cancel each other out, and debt will be a constant multiple of firm value (given the parameters). Hence there will be no effect on leverage.
What do Leary and Robert’s empircal results say about profitability’s effect on capital structure?
Here, increases in proftiability increaese the likelihood of leverage redutions and stimulate equity issuance. This is in sharp contrast to the results of the Leland model
How can the empirical observation that leverage tends to decrease in response to increases in profitability be explained?
This can be explained by a pecking-order theory, in which firms will prefer to finance projects by inside rather than outside finance. Hence an increase in profitability, would NOT lead the firm to issue more debt, but rather to lead leverage decrease as firm value increases
In Leland’s (1994 )model of capital structure, is it correct to say that increasing return volatility can increase the value of debt?
Yes, it can. Higher volatility will reduce the bankruptcy-point in terms of firm value. When the firm is close to bankruptcy, the dominating effect of a lower bankruptcy point will be increased debt value
What happens to equity value as volatility increases when debt is unprotected?
Equity value will go up. Equity is strictly convex in V when debt is unprotected
Why does a higher interest rate lead to a higher optimal leverage ratio in the Leland model?
Because higher interest payments increases the value of the tax shield, which induces higher leverage
Why may debt for firms with higher bankruptcy costs carry lower interest rates than for firms with lower bankruptcy costs?
Because higher bankruptcy costs leads to a lower optimal leverage ratio, leading to lower discount rates on debt
What is the key idea in the Leland model?
That firms trade-off the benefit of the tax shield and bankruptcy costs when deciding on their capital structure.
In the Leland model, what is the problem with the ex ante optimal bankruptcy point?
While it maximizes the equity value as a function of the optimal bankruptcy point at t_0, it is not credible. Equity holders will hold on to equity as long as it has any value ex post.
Why is equity value of convex function of firm value?
When the bankruptcy point is endogenously determined, equity has an ‘option’ like nature, with more exposure to upside than downside.
Why is equity value of convex function of firm value in the Leland model?
When the bankruptcy point is endogenously determined, equity has an ‘option’ like nature. it has more exposure to upside than downside.
How does leverage ratio depend on volatility in the Leland model?
D/V is strictly decreasing in volatility
