Capital Structure in a Perfect Market Flashcards

1
Q

What are internally generated funds?

A

Retained earnings/ Plowback profit

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2
Q

What are the external sources of finance?

A

Debt
Equity

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3
Q

Are internally or externally generated funds used more to finance corporations?

A

Internally generated funds

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4
Q

What is the more favourable external financing in the US market?

A

Debt issuing

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5
Q

What are thee transitional periods in the financing choice across a corporate life cycle?

A

1) Going from being a private business entirely funded by the owner to accessing the private equity markets (venture capital)
2) Going from private to public with an initial public offering
3) Public companies making seasoned offerings of debt and equity

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6
Q

At the early stages of a company, how do they tend to finance?

A

Through external debt (loans from banks) or the owner’s equity

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7
Q

After the early stages of a company, how does the company now tend to finance?

A

Initial Public Offering

  • Venture Capital
  • Common stock
  • Still low internal financing
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8
Q

In a public company that has been around for a few years, how do they tend to finance?

A
  • More internal financing
  • Common stocks
  • Warrants
  • Convertibles
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9
Q

How does a middle aged company tend to finance?

A
  • High internal financing
  • Debt
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10
Q

Who’s money does venture capitalists spend on investing?

A

Not their own, other peoples

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11
Q

Who are angel investors?

A

An angel investor is usually a high-net-worth individual who funds startups at the early stages, often with their own money.

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12
Q

In the final stages of a company, what happens to financing?

A
  • Retire debt
  • Repurchase stocks
  • Small internal funding
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13
Q

What does a corporate life cycle look like?

A

Look at slides

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14
Q

What can stop a company issuing out shares?

A

Entrepreneurs that have emotional attachment to their companies

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15
Q

For a company that was once small and grew rapidly and is now middle aged, what might influence how they finance?

A

Might be reluctant to finance through debt

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16
Q

What are warrants?

A

Security that entitles the holder to buy the underlying stock of the issuing company at a fixed price called exercise price until the expiry date

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17
Q

What is the pattern of financing?

A

Owner equity—-private equity—-public equity—–debt financing

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18
Q

what types of cost are present when issuing securities?(2)

A

Direct cost: due diligence, underwriting

Indirect cost: time, effort in conforming to accounting standards

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19
Q

What are the implications of a new equity announcement and why?

A

The announcement of a new equity issue is usually bad news for investors because it can be perceived as an attempt by management to sell overpriced stock

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20
Q

What are the choices of debt financing?

A

Fixed claim
Tax deductible
High priority in financial trouble
Fixed maturity
No management control

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21
Q

What are the choices of equity financing?

A

Residual claim
Not tax deductible
Low priority in financial trouble
Infinite life
Management control

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22
Q

Is debt and equity financing a fixed or a residual claim?

A

Debt= fixed claim
equity= residual claim

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23
Q

Is debt and equity financing tax deductable?

A

Debt= yes
Equity= no

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24
Q

Does debt or equity have higher priority in financial trouble?

A

Debt

25
Q

What is the mix of financing that is between debt and equity financing called?

A

Mezzanine (hybrid) finance

26
Q

What are examples of Mezzanine finance?

A

Convertible debt
Preferred stock

27
Q

Does debt and equity financing require management control?

A

Debt= no
Equity= yes

28
Q

Are bank loans or bonds & commercial papers more used to borrow?

A

Bank loans

29
Q

Why are bank loans sometimes used more than issuing bonds?

A

Company details only have to be revealed to the bank rather than releasing detail to the public

30
Q

What are common stocks?

A

Residual claim on assets and cash flow

31
Q

Who holds the majority of common stocks?

A

Financial institutions

32
Q

What are dual-class shares in terms of voting?

A

1 share 1 vote vs. 1 share 10 vote

33
Q

What are dual class stocks?

A

Dual-class stock is often designated Class A and Class B, where Class B is generally, but not always, the one with more potent voting status

34
Q

What are preferred stocks?

A

Stocks that lie between equity and debt (hybrid)

35
Q

Do preferred stocks or common stocks take priority?

A

Preferred stock

36
Q

When do preferred stocks gain voting rights?

A

if corporation fails to pay preferred dividend

37
Q

What is the net worth of a preferred stock?

A

Net worth = common equity + preferred equity

38
Q

What are the advantages of preferred stocks?

A

Dividends
Tax Advantages

39
Q

What are the disadvantages of preferred stocks?

A

Interest rate fluctuations
Floating Rate Preferred

40
Q

Why is a preferred stock like debt?

A

Preferred stock offers a series of fixed payments to the investor

41
Q

Do companies have to pay preferred dividends?

A

No

42
Q

Define capital structure.

A

The relative proportions of debt, equity, and other securities that a firm has outstanding

43
Q

What are the measures of capital structure in terms of financial leverage?

A

Debt-to-equity ratio
Leverage (gearing) ratio

44
Q

How do you calculate debt-to-equity ratio?

A

D/E = (D/V)/(1 – D/V)

45
Q

How do you calculate the leverage (gearing) ratio?

A

D/V = D/(D + E) = (D/E)/(D/E + 1)

46
Q

In a perfect world, changing a firm’s capital structure…

A

…should not affect its value to its shareholders

47
Q

What are the assumptions of the world in the capital structure decision?

A

There are no taxes

Managers have stockholder interests at heart and do what’s best for stockholders.

No firm ever goes bankrupt

Equity investors are honest with lenders; there is no subterfuge or attempt to find loopholes in loan agreements.

Firms know their future financing needs with certainty

Individual investors can borrow/lend at the same terms with the firm

48
Q

What is on the left hand side of a balance sheet?

A

Assets
Value of cash flows from the firm’s real assets and operations
Value of the firm

49
Q

What is on the right hand side of a balance sheet?

A

Liabilities and Stockholder’s Equity
Market value of debt
Market value of equity
Value of the firm

50
Q

Is the value of a firm affected by capital structure?

A

No

51
Q

What is the same on a balance sheet?

A

The value of the firm at the bottom of both sides

52
Q

Read slides 16-20

A
53
Q

What increases to equity shareholders as debt issuing of a firm increases? Why?

A

Risk- it is shared with less shareholders

54
Q

What does leverage not affect? What does it affect?

A

Operating risk of the firm is the same.
Financial risk of the firm

55
Q

Why are investors indifferent when deciding whether to invest in an all equity firm or a levered firm?

A

The return is the same- look at slide 19

56
Q

How do you calculate the expected return on assets (unlevered equity)?

A

rA= expected operating income / MV of all securities

= (proportion of debt x expected return on debt) + (proportion of equity x expected return on equity)

Look at slides

57
Q

What is the cost of capital of levered equity equal to?

A

To the cost of capital of unlevered equity plus a premium that is proportional to the debt-equity ratio

58
Q

All things equal…

The higher the leverage….

The lower the debt return….

A

…the higher the equity return

…. the higher the equity return