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FINC206 > Capital Structure (W5 + 6) > Flashcards

Capital Structure (W5 + 6) Flashcards

1
Q

Capital Structure is a combination of

A

Debt and Equity

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2
Q

Unlevered Firm

A

Fully financing assets with equity

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3
Q

Levered Firm

A

Financing assets with both debt and equity

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4
Q

Optimal Capital Structure

A

Maximises the value of the firm/minimises the firms cost of capital

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5
Q

Business Risk

A

Possibility that a company will have lower than expected profits/uncertainty about future operating income (EBIT)

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6
Q

Financial Risk

A

Additional risk concentrated on common stockholders as a result of financial leverage

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7
Q

Financial Leverage

A

Use of debt - more debt = more financial leverage = more financial risk –> concentrates business risk on stockholders

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8
Q

If a company has higher business risk should it choose to have more or less financial leverage?

A

Less - more likely to be affected by business risk, hence less additional risk is better.

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9
Q

If EBIT > break-even, leverage is…

A

beneficial - leverage exposes shareholders to more risk as EPS and ROE sensitive to changes in EBIT

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10
Q

For financial leverage to raise ROE, ROA must be

A

greater than the cost of debt (Rb) as if assets are more productive than the cost to fund them, the move of equity to debt on the balance sheet will be beneficial

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11
Q

Why does financial leverage not necessarily follow the capital structure?

A

Shareholders can adjust the amount of financial leverage by borrowing and lending on their own (homemade leverage)

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12
Q

Homemade leverage/unleverage

A

Use of personal borrowing/lending to alter the degree of financial leverage to which an individual is exposed to

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13
Q

Assumptions for MM1958 (no taxes) - Irrelevance Theorem (4)

A

Perfect capital markets
Homogenous expectations
Homogenous business risk classes
Perpetual cash flows

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14
Q

What does perfect capital markets look like? (3)

A

Perfect competition
All borrowing/lending at the same rate
Equal access to information
No tax, transaction costs, bankruptcy costs

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15
Q

MM (No Taxes) - Proposition 1

A

The value of the firm is not affected by leverage (VL = VU)

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16
Q

MM (No Taxes) - Proposition 2

A

Leverage increases the risk and return to stockholders

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17
Q

MM (No Taxes) - Proposition 3

A

Discount rate will be completely unaffected by capital structure of the firm

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18
Q

Importance of MM assumptions

A

Capital market imperfections will impede MM propositions.

19
Q

Effect of corporate taxes

A

When tax is involved there is a debt financing advantage (interest payments are tax deductible) creating a tax shield benefit.

20
Q

Why is a tax shield beneficial? (2)

A

Source of additional value for the firm and its shareholders
Additional value becomes part of shareholder’s residual claim after debt

21
Q

MM (1963 w/ taxes) - Proposition 1

A

In a world with corporate taxes, but no bankruptcy costs, value of the firm increases with leverage

22
Q

MM (1963 w/ taxes) - Proposition 2

A

Leverage increases the risk and return to stockholders

23
Q

MM (1963 w/ taxes) - Proposition 3

A

Company WACC declines with leverage as debt is a tax advantage relative to equity.

24
Q

Critiques of MM (2)

A

Personal tax disadvantage of debt vs. corporate tax advantage
Borrowers incur costs such as bankruptcy and agency costs.

25
Q

Bankruptcy Costs (Direct and Indirect)

A

Direct - legal and admin cost of liquidation or reorganisation
Indirect - impaired ability to conduct business

26
Q

Agency costs increase with…

A

Leverage as conflict arises between stockholders and bondholders, magnified by financial distress

27
Q

In times of financial distress stockholders are tempted to…

A

pursue selfish strategies

28
Q

3 Types of Selfish Strategies by Stockholders

A
  1. Incentive to take large risk - destroy value for bondholders and firm overall
  2. Incentive toward underinvestment - don’t invest in projects as requires the commitment of additional funds by stockholders to increase value for bondholders.
  3. Milking the property - payout extra dividends in times of financial distress leaving less in the form for bondholders.
29
Q

Techniques to reduce financial distress (2)

A

Protective covenants - agreement that limits certain actions
Debt consolidation - taking out a new loan to settle existing debt

30
Q

Positive Covenant

A

Company agrees to do something (e.g. maintain working capital to a certain level)

31
Q

Negative/Restrictive Covenants

A

Limit/prohibits certain actions the company may take (e.g. amount of dividend that can be paid)

32
Q

Costs of financial distress can be reduced but…

A

not eliminated, therefore firms will not finance entirely with debt.

33
Q

Static Trade Off Theory of Capital Structure

A

Trade-off between the tax advantage of debt and the costs of financial distress

34
Q

Optimal Capital Structure

A

Where the benefit from an additional dollar of debt is offset y the increase in expected bankruptcy costs.

35
Q

Agency Costs of Equity on Debt-Equity Financing (2)

A

Individuals will work harder for a firm if they are the owner rather than “hired help”
Individuals will work harder for a firm if they own a larger percentage.

36
Q

Personal Equity Income faces

A

Double taxation (firm and shareholder)

37
Q

Miller 1977 on Personal Taxes

A

If distribution to equity holders is taxed at a lower effective personal tax rate than interest, the tax advantage to debt at the corporate level is partially offset.

38
Q

Classical Tax System Characteristics (3)

A

Individuals face different tax rates
Different possible outcomes regarding indiviuals debt/equity preferences
Favours corporate debt (dividends tax credited)

39
Q

Imputation Tax System Characteristics (3)

A

Not common within larger markets
Company tax rate is effectively zero
Gain on leverage

40
Q

Under dividend imputation… (3)

A

Debt less attractive
More external equity financing optimal
Share repurchases have no impact on firm value.

41
Q

Pecking Order Theory - Firms prioritise financing into… (3)

A

Retained earnings - cheapest
Debt financing
Equity Financing

42
Q

Pecking Order Theory of Capital Structure

A

Debt has prior claim on assets and earnings (announcement of debt issue should have a smaller downward impact on share rpice)

43
Q

Main points of Pecking Order Theory (4)

A

Firms prefer internal finance
If external finance required, firms will issue safest security first debt before equity
If externally generated cash flows exceeds capital investment, surplus used to pay down debt rather than repurchase and retire equity.
Each firms debt ratio reflects requirement for external financing

FINC206 (8 decks)

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