Capital structure II

Question 1

What i the agency relationship and the cost/ benefits of leverage

Answer 1

*risk shifting–> managers may undertake risky projects which put debtholders at risk because they are only paid fixed interest and principal from successful projects –> essentially shareholders get the benefit of the investment at the expense of the lenders
* under investment–> agency cost of leverage management does not undertake good risky investments as it does not serve the purpose of the shareholders
* debt overhang-> inability for company to take new loans because the debt level is already so high
* cash out-> technique to take money out of the company in the form of dividends to shareholders because of future predictions of financial stress of the company

Benefits of leverage
* tax shield –> lower tax payable for company
* defining terms of conditions from debtholders to managers within contracts which disciplines management

Question 2

Explain tradeoff theory

Answer 2

• when a company balances the costs and benefits of incorporating debt and equity in its capital structure

VL= VU + PV(interest tax shield) + PV(financial distress costs) - PV(Agency costs of debt) + PV(Agency benefits of Debt)

Question 3

what is pecking order theory?

Answer 3

• where the company will always go for using retained earnings, then debt, then equity financing
• in these circumstances company prefers to not issue shares:
  1. when share prices are undervalued in the market

Question 4

what type of agency problem occurs when shareholders gain from decisions that increase the risk of the firm even if they have negative NPV?

Answer 4

• risk shifting

Question 5

what is corporate perks?

Answer 5

• when managers waste resources on corporate perks such as limo, driver, country club memberships or private jets usually in the form of fringe benefits

Question 6

what is empire building?

Answer 6

• when managers undertake investment that may be unprofitable (-NPV) to increase the reputation, image, salary or to signalt to the market efficiency, but not necessarily the firms profitability
• here, corporate perks and empire buildings are examples of agency costs

Question 7

what factors influences a firms choise of capital structure?

Answer 7

• taxes
• agency costs and benefits of leverage
• signalloing and adverse selection