Ch 11 Flashcards
Sovereign Debt
Issued by the national government. In the US, sovereign debt is issued as bonds called “Treasury securities”
Treasury Bills
These are zero-coupon bonds with maturities shorter than 1 year.
Treasury Notes
These are semiannual coupon bonds with maturities ranging from 1 to 10 years.
Treasury Bonds
These are semiannual coupon bonds with maturities longer than 10 years.
Treasury Inflation-Protected Securities (TIPS)
These are semiannual coupon bonds where the principal is adjusted for inflation. Because the coupon rate is fixed, the coupon payment is also adjusted for inflation.
Perfect Capital Markets 3 Assumptions
Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.
No taxes, transaction costs, or issuance costs.
The financing and investment decisions are independent of each other.
Revenue Bonds
Revenue bonds are backed by the revenues that the projects will earn as a result of the debt issued.
General Obligation Bonds
These bonds are backed by the full faith and credit of a local government. If local governments strengthen the commitment further by tying the promise to a particular revenue source, this commitment is over and above the usual commitment, and the bonds are called double-barreled.
Interest Tax Shield
The use of debt results in tax savings for the firm, which adds to the value of the firm.
Interest tax shield=PV(Interest payments)
from permanent debt it equals the corporate tax rate times the debt.
Default
A firm that fails to make its required payments to debt holders is said to default on its debt
Bankruptcy
After a firm defaults, the debt holders have claims to the firm’s assets through a legal process called bankruptcy
Perfect Capital Markets 3 Assumptions
Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.
No taxes, transaction costs, or issuance costs.
The financing and investment decisions are independent of each other.
MM Propositions 1 Perfect Capital Markets
The total value of a firm is equal to the market value of the total cash flows generated by its asset.
The value of a firm is unaffected by its choice of capital structure.
Changing a firm’s capital structure merely changes how the value of its assets is divided between debt and equity, but no the firms’s total value.
V(L) =V(U)
MM Proposition 2 Perfect Capital Markets
The CoC of levered equity increases with the firm’s debt-to-equity.
Because we have no taxes in a perfect capital market, the firm’s WACC and the unlevered CoC are equal.
Interest Tax Shield
The use of debt results in tax savings for the firm, which adds to the value of the firm.
Interest tax shield=PV(Interest payments)
from permanent debt it equals the corporate tax rate times the debt.
Managerial Entrenchment
Because managers face little threat of being replaced, managers can run the firm to suit their interests.
Reason Leverage can provide incentives for managers to run a firm more efficiently and effectively (3)
Increased ownership concentration
Reduced wasteful investment
Reduced managerial entrenchment and increased commitment
Free Cash Flow Hypothesis
Wasteful spending is more likely to happen when firms have high levels of cash flow in excess of what is needed.
Asymmetric Information
When managers have more information about a firm than investors
Who bears the Financial Distress Costs?
Debt holders reorganize that when the firm defaults, they will not be able to obtain the full value of the assets. As a result they will pay less (or demand higher yields) for the debt initially.
It is the equity holders who most directly bears the financial distress costs.
Adverse Selection
A seller with private information is likely to sell you worse-than-average goods
Credibility Principal
Claim’s on one’s self -interest are credible only if they are supported by actions that would be too costly to take if the claims were untrue.
Reason Leverage can provide incentives for managers to run a firm more efficiently and effectively (3)
Increased ownership concentration
Reduced wasteful investment
Reduced managerial entrenchment and increased commitment
Managers issuing debt viewed from investors
Issuing more debt it typically viewed as a positive signal as the company is taking on commitment to make timely interest and principal payments
Adverse Selection Implications for Equity Issuance
The stock price declines on the announcement of an equity issue
The stock price tends to rise prior to the announcement of an equity issue
Firms tend to issue equity when information asymmetries are minimized, such as immediately after earnings announcement
Pecking Order Hypothesis
Managers prefer to make financing choices that send positive rather than negative signals to outside investors
- Internal generated equity(i.e retained earnings)
- Debt
- External Equity (i.e newly issued shares)
Cash Flow Perspective
Associating cash inflows with positive signs and cash outflows with negative signs
Cost Flow Perspective
Associating cash inflows with negative signs and cash outflows with positive signs
When to use Cash Flow Perspective
- Whenever a problem deals with cashflow-related items such as net cash flows or profits.
- To synthetically create an asset. This is because it is easier to identify the cash flows needed to replicate the desired position when using the cash flow perspective.
- To exploit arbitrage using the two-step approach of moving everything to the greater than side of the inequality, as presented above.
