Capital Structure In Practice Flashcards
What are the three questions to ask yourself when it comes to changing the CS?
- To change or not to change the CS?
- If we change, at what speed should we do it?
- How should we change it?
What are the two reasons to change the CS for under-levered firm?
⬆️ MV of firm
Under-levered firms can be subject to hostile takeover
What are the two ways to take over a company? In what context does it happen?
- Agreement
- Buying stocks of the company
When a firm is under-levered.
What are the two reasons not to change the CS for an under-levered firm?
- Maintain financial flexibility
- Possibility to take on debt in the future
- Firm can borrow and buy back shares = ⬆️ D/E)
- Weak tolerance for risk (risk averse)
- Reminder: ⬆️Debt = ⬆️ risk = ⬆️ Default probability
- Preferences of managers and/or SH
What are the two reasons to change the CS for over-levered firm?
- ⬇️ the probability of bankruptcy
- ⬆️ the MV of the firm
What is the reason not to change the CS for over-levered firm?
If the industry or the firm is protected from bankruptcy by the government:
- Guarantees their debt to banks
- Access to capital during financial difficulties
What is the main advantage of fast change of CS?
Rapid increase in firm’s MV
⬆️ MV = ⬆️ Stock price
What is the main advantage of a gradual change of CS?
Does not destabilize the firm environment (allows to adapt and proceed prudently)
- Gives investors more time, they can be cautious
What are the 4 factors to consider to determine the speed of change?
- Confidence of the manager in Optimal CS calculation
- Comparison to industry’s level of financial leverage
- Threat from hostile takeover
- Need for flexibility
Name the speed to take if manager is certain or uncertain on the exact level.
(Factor 1: Confidence in Optimal CS Calculation)
If uncertain: gradual (so manager can take small steps)
If certain: rapidly
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)
If Optimal CS is different: gradual (investors will have more time to compare)
If Optimal CS is similar: rapidly
If there is threat from hostile takeover, what should be the speed of the CS change?
If threat: Rapid change
If no threat: Gradual change
If the firm needs flexibility, what is the speed if the firm is under-levered or over-valued?
Firm is under-valued: gradual
Firm is over-valued: rapid
What are the four possible ways to change CS?
- Financial Restructuring
- Sell Asstes
- New project financing
- Change dividend policy
Which approach of CS change is the most direct?
Financial Restructuring
What is the speed of change for the financial restructuring approach?
Rapid
Explain how the financial restructuring approach work for an under-levered or over-levered firm and what happens to the D/E ratio.
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
What is the inconvenient from the financial restructuring approach?
High issuance costs
Why is paying dividends will reduce a firm’s equity?
Because div are paid from free CF so ⬇️E that belongs to common SH
What is the speed of change for the selling assets approach?
As rapid as selling assets can be
Explain how the selling assets approach work for under-levered and over-levered firms.
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
What is the limit of selling assets in order to change CS.
The firm must have non-essential assets, with no link to positive NPV projects
What does liquidity mean?
Easy to sell (assets)
Easy to convert to cash which is the most liquid asset
What is the speed of change for the new project financing approach?
Gradual change, as projects are started
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
What is the inconvenience of financing a new project in order to change the CS?
Nothing
What is the speed of change for the change of dividend policy approach?
Gradual
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
What are the types of equity capital?
- SH wealth from start
- Personal wealth and Family Capital
- Angel Investors
- Venture Capital Firms (VC)
- Capital Markets
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
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
What is the disadvantage of personal and family capital?
Limited amount of investors
What is an angel investors?
Informal capital
Private (particular) investors
Provide capital directly to firm
No guarantee required
No relationship ties
What are the characteristics of angel investors? (5)
- High income, extensive education
- Work-related success
- Investments are made locally
- High business experience (🚫lawyers, doctors)
- Not much financial analysis (decisions taken instinctively and not scientifically)
What are the three types of angel investors?
- Economic investor (economic motivation)
- Hedonistic investor (satisfaction in encouraging entrepreneurial process)
- Altruistic investor (want to give back to society once having experienced success)
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
What are the three problems with Angel Investors?
- Angel discretion and invisibility
- Bad communication channels
- Rarity of interesting projects: Significant supply of venture-capital firms
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
What are the 6 characteristics of VCs?
- Investment in equity or convertible bonds
- High required return
- LT Participation but non-permanent (3-8 years)
- Involved in company management
- Exit mechanism planned
- Investments generally greater than $1M
What are capital markets (type of equity capital)?
Firms issue stocks via stock market
IPO: Initial public offering
What are the three characteristics of capital markets?
- Large pool of investors
- High issuance costs
- Generally for amounts greater than $10M
- Often for amounts superior to $100M
What are the 5 advantages of IPO (capital markets)?
- Access to equity capital
- Easier access to borrowing
- First investors get large returns
- Enhanced liquidity of stock once company goes public
- Enhanced firm visibility and credibility
What are the 5 disadvantages of IPO (capital markets)?
- Cost: time and money
- Verification and accounting fees, legal fees, administrator remuneration, remuneration of fund distributors
- Loss of confidentiality (higher visibility)
- All becomes public, no secret (strict regulation regarding disclosures)
- Loss of flexibility
- Rigid structure
- Pressure for returns, LT vision is compromised
- Investors and analyst expectations
- Call options
- Loss of control
- Dilution of capital
What are the three approach in choosing the type of equity capital?
- Is the capital market attractive for SME?
- Function of life-cycle phase
- Growth vs Control Dilemma
Is the capital market attractive for SME?
No, since:
- Too costly
- No need for such financing
- Will not satisfy the Exchange listing requirements
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
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
What are the different types of debt?
- Private debt
- Public Debt
What is private debt?
ST and LT bank loans (financial liability)
Accounts payable (operational liability)
What is public debt?
- Securitization e.g assets back securities
- Banker’s acceptance
- Commercial paper
- Debentures
- Bonds
What are the advantages of private debt?
No issuance costs
Possibility to negotiate terms directly with creditors
What are the advantages of public debt?
Larger pool of investors
Less monitoring
What are the characteristics of bonds? (4)
- Coupon rate, maturity and nominal value
- Goal of borrowing
- Backed securities/ priority ranking
- Repurchase at issuer’s discretion or not (i.e callable/potable, etc)
What are the 5 goals of restrictive clauses of bonds?
- Reduce agency costs between SH and creditors
- Clause limiting the use of funds
- Clause limiting sale of asset-backed securities
- Clause limiting dividend payments
- Clause limiting future indebtedness
