Capital Structure in a Perfect Market Flashcards
What are internally generated funds?
Retained earnings/ Plowback profit
What are the external sources of finance?
Debt
Equity
Are internally or externally generated funds used more to finance corporations?
Internally generated funds
What is the more favourable external financing in the US market?
Debt issuing
What are thee transitional periods in the financing choice across a corporate life cycle?
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
At the early stages of a company, how do they tend to finance?
Through external debt (loans from banks) or the owner’s equity
After the early stages of a company, how does the company now tend to finance?
Initial Public Offering
- Venture Capital
- Common stock
- Still low internal financing
In a public company that has been around for a few years, how do they tend to finance?
- More internal financing
- Common stocks
- Warrants
- Convertibles
How does a middle aged company tend to finance?
- High internal financing
- Debt
Who’s money does venture capitalists spend on investing?
Not their own, other peoples
Who are angel investors?
An angel investor is usually a high-net-worth individual who funds startups at the early stages, often with their own money.
In the final stages of a company, what happens to financing?
- Retire debt
- Repurchase stocks
- Small internal funding
What does a corporate life cycle look like?
Look at slides
What can stop a company issuing out shares?
Entrepreneurs that have emotional attachment to their companies
For a company that was once small and grew rapidly and is now middle aged, what might influence how they finance?
Might be reluctant to finance through debt
What are warrants?
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
What is the pattern of financing?
Owner equity—-private equity—-public equity—–debt financing
what types of cost are present when issuing securities?(2)
Direct cost: due diligence, underwriting
Indirect cost: time, effort in conforming to accounting standards
What are the implications of a new equity announcement and why?
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
What are the choices of debt financing?
Fixed claim
Tax deductible
High priority in financial trouble
Fixed maturity
No management control
What are the choices of equity financing?
Residual claim
Not tax deductible
Low priority in financial trouble
Infinite life
Management control
Is debt and equity financing a fixed or a residual claim?
Debt= fixed claim
equity= residual claim
Is debt and equity financing tax deductable?
Debt= yes
Equity= no
Does debt or equity have higher priority in financial trouble?
Debt
What is the mix of financing that is between debt and equity financing called?
Mezzanine (hybrid) finance
What are examples of Mezzanine finance?
Convertible debt
Preferred stock
Does debt and equity financing require management control?
Debt= no
Equity= yes
Are bank loans or bonds & commercial papers more used to borrow?
Bank loans
Why are bank loans sometimes used more than issuing bonds?
Company details only have to be revealed to the bank rather than releasing detail to the public
What are common stocks?
Residual claim on assets and cash flow
Who holds the majority of common stocks?
Financial institutions
What are dual-class shares in terms of voting?
1 share 1 vote vs. 1 share 10 vote
What are dual class stocks?
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
What are preferred stocks?
Stocks that lie between equity and debt (hybrid)
Do preferred stocks or common stocks take priority?
Preferred stock
When do preferred stocks gain voting rights?
if corporation fails to pay preferred dividend
What is the net worth of a preferred stock?
Net worth = common equity + preferred equity
What are the advantages of preferred stocks?
Dividends
Tax Advantages
What are the disadvantages of preferred stocks?
Interest rate fluctuations
Floating Rate Preferred
Why is a preferred stock like debt?
Preferred stock offers a series of fixed payments to the investor
Do companies have to pay preferred dividends?
No
Define capital structure.
The relative proportions of debt, equity, and other securities that a firm has outstanding
What are the measures of capital structure in terms of financial leverage?
Debt-to-equity ratio
Leverage (gearing) ratio
How do you calculate debt-to-equity ratio?
D/E = (D/V)/(1 – D/V)
How do you calculate the leverage (gearing) ratio?
D/V = D/(D + E) = (D/E)/(D/E + 1)
In a perfect world, changing a firm’s capital structure…
…should not affect its value to its shareholders
What are the assumptions of the world in the capital structure decision?
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
What is on the left hand side of a balance sheet?
Assets
Value of cash flows from the firm’s real assets and operations
Value of the firm
What is on the right hand side of a balance sheet?
Liabilities and Stockholder’s Equity
Market value of debt
Market value of equity
Value of the firm
Is the value of a firm affected by capital structure?
No
What is the same on a balance sheet?
The value of the firm at the bottom of both sides
Read slides 16-20
What increases to equity shareholders as debt issuing of a firm increases? Why?
Risk- it is shared with less shareholders
What does leverage not affect? What does it affect?
Operating risk of the firm is the same.
Financial risk of the firm
Why are investors indifferent when deciding whether to invest in an all equity firm or a levered firm?
The return is the same- look at slide 19
How do you calculate the expected return on assets (unlevered equity)?
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
What is the cost of capital of levered equity equal to?
To the cost of capital of unlevered equity plus a premium that is proportional to the debt-equity ratio
All things equal…
The higher the leverage….
The lower the debt return….
…the higher the equity return
…. the higher the equity return
