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Capital Structure In Practice Flashcards

1
Q

What are the three questions to ask yourself when it comes to changing the CS?

A
  1. To change or not to change the CS?
  2. If we change, at what speed should we do it?
  3. How should we change it?
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2
Q

What are the two reasons to change the CS for under-levered firm?

A

⬆️ MV of firm
Under-levered firms can be subject to hostile takeover

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3
Q

What are the two ways to take over a company? In what context does it happen?

A
  1. Agreement
  2. Buying stocks of the company

When a firm is under-levered.

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4
Q

What are the two reasons not to change the CS for an under-levered firm?

A
  1. Maintain financial flexibility
    • Possibility to take on debt in the future
    • Firm can borrow and buy back shares = ⬆️ D/E)
  2. Weak tolerance for risk (risk averse)
    • Reminder: ⬆️Debt = ⬆️ risk = ⬆️ Default probability
    • Preferences of managers and/or SH
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5
Q

What are the two reasons to change the CS for over-levered firm?

A
  1. ⬇️ the probability of bankruptcy
  2. ⬆️ the MV of the firm
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6
Q

What is the reason not to change the CS for over-levered firm?

A

If the industry or the firm is protected from bankruptcy by the government:
- Guarantees their debt to banks
- Access to capital during financial difficulties

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7
Q

What is the main advantage of fast change of CS?

A

Rapid increase in firm’s MV
⬆️ MV = ⬆️ Stock price

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8
Q

What is the main advantage of a gradual change of CS?

A

Does not destabilize the firm environment (allows to adapt and proceed prudently)
- Gives investors more time, they can be cautious

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9
Q

What are the 4 factors to consider to determine the speed of change?

A
  1. Confidence of the manager in Optimal CS calculation
  2. Comparison to industry’s level of financial leverage
  3. Threat from hostile takeover
  4. Need for flexibility
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10
Q

Name the speed to take if manager is certain or uncertain on the exact level.
(Factor 1: Confidence in Optimal CS Calculation)

A

If uncertain: gradual (so manager can take small steps)

If certain: rapidly

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11
Q

Name the speed to take if the optimal CS is different or similar from the level in the industry.
(Factor 2: Comparison to industry’s level of financial leverage)

A

If Optimal CS is different: gradual (investors will have more time to compare)

If Optimal CS is similar: rapidly

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12
Q

If there is threat from hostile takeover, what should be the speed of the CS change?

A

If threat: Rapid change

If no threat: Gradual change

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13
Q

If the firm needs flexibility, what is the speed if the firm is under-levered or over-valued?

A

Firm is under-valued: gradual

Firm is over-valued: rapid

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14
Q

What are the four possible ways to change CS?

A
  1. Financial Restructuring
  2. Sell Asstes
  3. New project financing
  4. Change dividend policy
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15
Q

Which approach of CS change is the most direct?

A

Financial Restructuring

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16
Q

What is the speed of change for the financial restructuring approach?

A

Rapid

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17
Q

Explain how the financial restructuring approach work for an under-levered or over-levered firm and what happens to the D/E ratio.

A

If firm is under-levered: issue debt (⬆️Debt), pay dividends, repurchase shares (⬇️E) —> ⬆️ D/E

If firm is over-levered: issue equity (⬆️Equity), reimburse debt —> ⬇️ D/D

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18
Q

What is the inconvenient from the financial restructuring approach?

A

High issuance costs

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19
Q

Why is paying dividends will reduce a firm’s equity?

A

Because div are paid from free CF so ⬇️E that belongs to common SH

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20
Q

What is the speed of change for the selling assets approach?

A

As rapid as selling assets can be

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21
Q

Explain how the selling assets approach work for under-levered and over-levered firms.

A

Selling assets will provide CF

If under-levered: use the CFs to pay dividends and repurchase stocks

If over-levered: use the CFs to reimburse debt

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22
Q

What is the limit of selling assets in order to change CS.

A

The firm must have non-essential assets, with no link to positive NPV projects

23
Q

What does liquidity mean?

A

Easy to sell (assets)
Easy to convert to cash which is the most liquid asset

24
Q

What is the speed of change for the new project financing approach?

A

Gradual change, as projects are started

25
Explain how financing a new project work for changing the CS for an under-levered and over-levered firm.
If firm is under-levered: finance new projects with debt If firm is over-levered: finance new projects with equity
26
What is the inconvenience of financing a new project in order to change the CS?
Nothing
27
What is the speed of change for the change of dividend policy approach?
Gradual
28
Explain how changing the dividend policy to change the CS work for an under-levered and over-levered firm.
If firm is under-levered: increase dividends - ⬇️ MV if equity - ⬆️ of D/E If firm is over-levered: reduce dividends - ⬆️MV of equity - ⬇️ of D/E
29
What are the types of equity capital?
1. SH wealth from start 2. Personal wealth and Family Capital 3. Angel Investors 4. Venture Capital Firms (VC) 5. Capital Markets
30
Explain the SH wealth from start type of capital. Where does the money come from?
SH inject capital themselves into the company Originates from their personal fortune The potential coming from this source of financing is generally limited
31
Explain the personal wealth and family capital type of capital. Where does the money come from?
Equity comes from personal contacts of SH - Essentially friends and family - interesting financing for firm because: - Required return is usually smaller than conventional equity capital - Patient investors
32
What is the disadvantage of personal and family capital?
Limited amount of investors
33
What is an angel investors?
Informal capital Private (particular) investors Provide capital directly to firm No guarantee required No relationship ties
34
What are the characteristics of angel investors? (5)
1. High income, extensive education 2. Work-related success 3. Investments are made locally 4. High business experience (🚫lawyers, doctors) 5. Not much financial analysis (decisions taken instinctively and not scientifically)
35
What are the three types of angel investors?
1. Economic investor (economic motivation) 2. Hedonistic investor (satisfaction in encouraging entrepreneurial process) 3. Altruistic investor (want to give back to society once having experienced success)
36
What are the characteristics of investments from Angel Investors?
- Small amounts (usually inferior to 100 000$) - Steps for start-up and launch - More receptive to entrepreneurial needs than venture capital - Smaller refusal rate - Longer time horizon - Smaller required return - Less interference with company management
37
What are the three problems with Angel Investors?
1. Angel discretion and invisibility 2. Bad communication channels 3. Rarity of interesting projects: Significant supply of venture-capital firms
38
What is a venture capital firm (VC)?
- Financing for firms with a high level of risk - Start-up SME’s - High-growth businesses - Businesses undergoing restructuring
39
What are the 6 characteristics of VCs?
1. Investment in equity or convertible bonds 2. High required return 3. LT Participation but non-permanent (3-8 years) 4. Involved in company management 5. Exit mechanism planned 6. Investments generally greater than $1M
40
What are capital markets (type of equity capital)?
Firms issue stocks via stock market IPO: Initial public offering
41
What are the three characteristics of capital markets?
1. Large pool of investors 2. High issuance costs 3. Generally for amounts greater than $10M - Often for amounts superior to $100M
42
What are the 5 advantages of IPO (capital markets)?
1. Access to equity capital 2. Easier access to borrowing 3. First investors get large returns 4. Enhanced liquidity of stock once company goes public 5. Enhanced firm visibility and credibility
43
What are the 5 disadvantages of IPO (capital markets)?
1. Cost: time and money - Verification and accounting fees, legal fees, administrator remuneration, remuneration of fund distributors 2. Loss of confidentiality (higher visibility) - All becomes public, no secret (strict regulation regarding disclosures) 3. Loss of flexibility - Rigid structure 4. Pressure for returns, LT vision is compromised - Investors and analyst expectations - Call options 5. Loss of control - Dilution of capital
44
What are the three approach in choosing the type of equity capital?
1. Is the capital market attractive for SME? 2. Function of life-cycle phase 3. Growth vs Control Dilemma
45
Is the capital market attractive for SME?
No, since: - Too costly - No need for such financing - Will not satisfy the Exchange listing requirements
46
Explain the function of life-cycle phase (to choose the type of equity capital)
Small firms: not many options Listed or large firms: more options Firms become listed when size increases or when uncertainty is reduced Neglect VC since it takes up a too large portion of control
47
Explain the growth vs Control Dilemma (to choose the type of equity capital)
Entrepreneurs often face a trade-off between control and growth if they want the firm to reach its full potential Might refuse to trade-off control in exchange of growth
48
What are the different types of debt?
1. Private debt 2. Public Debt
49
What is private debt?
ST and LT bank loans (financial liability) Accounts payable (operational liability)
50
What is public debt?
- Securitization e.g assets back securities - Banker’s acceptance - Commercial paper - Debentures - Bonds
51
What are the advantages of private debt?
No issuance costs Possibility to negotiate terms directly with creditors
52
What are the advantages of public debt?
Larger pool of investors Less monitoring
53
What are the characteristics of bonds? (4)
1. Coupon rate, maturity and nominal value 2. Goal of borrowing 3. Backed securities/ priority ranking 4. Repurchase at issuer’s discretion or not (i.e callable/potable, etc)
54
What are the 5 goals of restrictive clauses of bonds?
1. Reduce agency costs between SH and creditors 2. Clause limiting the use of funds 3. Clause limiting sale of asset-backed securities 4. Clause limiting dividend payments 5. Clause limiting future indebtedness

Financial Management (2 decks)

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