Capital Structure Theory Flashcards
What is the Modigliani-Miller Irrelevance Theorem?
Under perfect capital market the choice of capital structure is irrelevant
Vu = VL (=EL + DL)
What are the two Fallacies MM Theorem debunks?
- ) “Debt is better because Debt is cheaper than equity”
2. ) “Debt is better when it makes EPS go up”
What is the hidden cost of equity?
Raising more debt makes existing equity more risky/expensive; rE increases as D/V increases; rA is unaffected by leverage
What is wrong with argument that companies should choose their financial policy to maximize their EPS?
- ) EBIT is unaffected by change in capital structure
- ) Creditors receive the safe part of EBIT
- ) Expected EPS might increase but EPS has become riskier
- ) Be careful comparing P/E ratios of companies with different capital structures.
Why do we observe equity at all?
- ) Maybe tax advantage of debt is not so big if we include personal taxes and not only corporate taxes
2) Perhaps high leverage costs induce other costs off-setting the tax shield
What effects do Personal Taxes have?
Personal Tax rates affect the required return on each source of funds (debt and equity)
- Investors have to pay personal taxes on all distributed cash flows -> coupon payments and dividends/capital gains
- Investors’ return from debt and equity are taxed differently in general -> differences may affect decision to have more or less debt; debt is tax disadvantaged
How does tax disadvantage of debt at the personal level affect the firm?
If investors pay lower taxes on equity income than on debt income then they will require a lower pretax return on equity than debt; making cost of capital lower if it issues equity
Who are the 3 claimants on Firms cash flows?
Debt holders, equity owners, and the government
What is the MM irrelevance theorem?
under perfect market conditions, the firm’s capital structure does not affect overall value
What fallacy does MM exploit regarding capital structure?
debt is cheaper than equity:-debt holders require a lower return than equity- less risk - ignores the hidden cost of debt, higher debt company holds the more equity holders begin to demand,-D/V increases, Re increases
How do personal taxes factor into the MM model?
-debt and equity are taxed differently at the personal level: debt usually has tax disadvantage -debt tax disadvantage causes a higher pretax rate of return for debt –> if lower taxes on equity, lower demanded return –> cost of capital will be lower if firm issues equity
Why can we ignore the impact of personal taxes on capital structure?
- we would have to know the tax brackets of all investors to get a true valuation-tax clienteles, changing capital structure causes a change in tax clientele not value
What are bankruptcy costs (BCs)?
direct costs - lawyers and judge fees, prolonged litigation
What are costs of financial distress (COFD)?
Indirect costs:-lose customers-lose suppliers-lose employees-fail to react to competitors-inability to raise capital to make investments
What is the effect of BCs and COFDs on the firm’s capital structure?
More BCs and COFDs = less debt E(BC) and COFD increase with more leverage = must be subtracted from the value of the levered firmVu = Vl + PV(TS) - PV(E(BC)) - P(COFD)
STATIC TRADEOFF THEORY OF CAPITAL STRUCTURE - What is the tradeoff regarding bankruptcy costs and capital structure?
Trade off = tax advantage of leverage vs the disadvantage of leverage caused by COFD and BCs More risk = less debt
What does the probability of bankruptcy depend on?
the volatility of cash flows
What is the conclusion on bankruptcy costs?
-too small to be driving down the value of the levered firm, but the expectation (probability) of bankruptcy does generate some costs- firms at risk of bankruptcy will likely not issue debt, so debt issuance is a sign of management confidence
What are the three primary costs of financial distress?
- breakdown of inter-temporal relations
- loss of intangible assets and strategic weaknesses
- fire-sale liquidation
What is inter-temporal relations breakdown?
when a company is close to bankruptcy, fewer people want to do business with it because it is seen as risky-hard to raise capital - who would invest-employees demand wage premium for stigma- suppliers will not ship to you -customers fear warranties not honored
Give examples of intangible assets and strategic weaknesses
- intangible assets - management, employees, experience, knowledge - all leave and join competitor
- strategic weakness - competitors could smell blood and become aggressive to put you out of business
What is the dark side of debt?
Bankruptcy Costs and Costs of Financial Distress
Direct Costs- Lawyers/Judges costs alot
Indirect- loss of customers, loss of suppliers, employees may leave
More financial distress costs-> less debt
What is the Static Trade-Off Theory of Capital Structure
There is a trade off between the tax advantage of leverage and the disadvantage caused by costs of financial distress and bankruptcy
More Risk = More Debt
More Financial Distress Costs = Less Debt
What is debt overhang?
- Management passes up positive NPV project because large interest payments are already promised to the debt holders
- can solve by issuing new senior debt
what is the problem with issuing new senior debt?
often decreases the value of the old senior debt
What is debt overhang?
Management passes up positive NPV project because large interest payments are already promised to the debt holders
what is the problem with issuing new senior debt?
often decreases the value of the old senior debt
What are the benefits of debt?
- restricts cash of management - monitoring role
- threats of bankruptcy keeps managers on toes- won’t spend cash on perks if they know that they will have to pay out in distress
