Capital Structure Theory Flashcards
Define the M&M Theorem.
Financial theory stating market value of firm is:
- determined by its earning power and risk of its underlying assets
- independent of the way it chooses to finance its investments or distributes dividends
What are the six assumptions in the M&M Theorem?
1) No Taxes
2) No Bankruptcy Costs
3) Inv. of firm aren’t affected by capital structure
4) No agency costs
5) Symmetric info
6) Efficient markets
Is the following statement regarding the cost of capital true?
“Debt is better because debt is cheaper than equity.”
- False
- Ignores “hidden” costs of equity
- Increasing amount of debt in capital structure makes equity more risky
Is the following statement regarding EPS true?
“Debt is better when it makes EPS go up”
- False
- Expected EPS may increase but EPS now riskier
What is the role of M&M?
Tells us where to look when examining capital structure (answer lies in one of the six assumptions)
If a company’s debt burden is too high, the company will have trouble doing what?
Paying off the debt (so we need to consider expected bankruptcy costs and costs of financial distress)
Are bankruptcy costs direct or indirect costs?
- Direct costs
- Observable (how much co. loses to legal fees in bankruptcy)
Are the costs of financial distress direct or indirect costs?
- Indirect costs
- Other things equal, the more the financial distress costs, the less debt a company is willing to take on
What are three key costs of financial distress?
1) Breakdown of intertemporal relations
2) Loss of intangible assets and strategic weakness
3) Fire sale liquidation
Explain agency costs.
- Equity has residual claim but has control of co.
- Management represents equity holders of firm.
- If there is leverage in capital structure, management may take some neg. NPV projects and reject some positive NPV projects
