Capital Structure And Leverage

Question 0

What are two non tax capital structure theories

Answer 0

MM Proposition I: cap structure irrelevant, value of firm unaffected; VL = VU
MM Proposition II: cost of equity increases linearly as a company increases debt; ^debt offset by ^equity cost

Question 1

What is objective of a company’s capital structure decision

Answer 1

Determine optimal proportion of debt and equity financing that minimize WACC and maximize firm value

Question 2

What are two with tax capital structure theories

Answer 2

MM Proposition I: value maximized at 100% debt due to tax shield; VL = VU + (t*d)
MM Proposition II: WACC minimized at 100% debt; ^leverage = v WACC

Question 3

What are costs of financial distress?

Answer 3

1. Direct/indirect costs of financial distress and bankruptcy
2. Probability of financial distress (^leverage = ^financial distress)

Question 4

What are net agency costs of equity

Answer 4

Monitoring costs
Bonding costs
Residual losses

Result from conflict of interest between managers and owners

Question 5

What is pecking order theory

Answer 5

Management prefer financing that sends least possible signals;

Internal capital > debt > equity

Question 6

What is static trade off theory

Answer 6

Managers will try to balance benefits of debt/tax savings with costs of financial distress; optimal structure exists

VL = VU + (t*d) - PV(costs of financial distress)

Question 7

Factors to look out for when analyzing firms cap structure

Answer 7

Change in cap structure over time
Cap structure of competitors
Factors affecting agency costs (corp gov quality)

Question 8

What are International factors affecting financial leverage

Answer 8

Institutional, legal and taxation
Financial market/banking system
Macroeconomic factors