Ch. 17: Does Debt Policy Matter? Flashcards
“If you are able to borrow money in the bank at 6% while your stockholders expect a return of 15% then it is clearly better to borrow money in the bank”
Is this true?
Not necessarily.
First of all, it makes sense that the cost of debt is lower than the cost of equity.
Secondly, this decision has to take account for the firm’s current capital structure and how much additional leverage it can pursue whilst maintaining a healthy financing base where bankruptcy and financial distress costs are minimized/ avoided
The cost of debt tend to be lower than cost of equity
True/ False
Debt financing tends to carry lower risk for the debtholder than equity financing does for the shareholder. Thus, going from fully equity financed to partly debt financed decreases the firm’s overall risk and thus WACC
The capital structure is a mix of securities at _____ value that is used to finance real investments by corporations.
Market/ Book
The capital structure is a mix of securities at MARKET value that is used to finance real investments by corporations.
Which of the following determinants impact the optimal capital structure?
A) Taxes
B) Cost of bankruptcy and financial distress
C) Costs of writing and enforcing complicated debt contracts (transaction costs of financing)
D) Effects of debt on incentives for management (disciplinary effects)
E) Differences created by imperfect information (insiders know more than outsiders, which may impact financing decisions)
F) Management experience with debt management
A) Taxes
B) Cost of bankruptcy and financial distress
C) Costs of writing and enforcing complicated debt contracts (transaction costs of financing)
D) Effects of debt on incentives for management (disciplinary effects)
E) Differences created by imperfect information (insiders know more than outsiders, which may impact financing decisions)
Not F
Following the static trade-off theory of capital structure, there is 1 main advantage and 1 main disadvantage of debt leading to a choice of target debt ratio. Which?
Advantage: interest tax shield (value-enhancing)
Disadvantage: cost of financial distress (value-destroying)
Which of the following statements does NOT hold true for the pecking-order theory for financing choices?
A) Firms’ financing is arranged to mitigate problems created by differences in information between managers (insiders) and investors (outsiders)
B) Asymmetric information affects the choice between internal and external financing and between new issues of debt and equity securities, leading to a pecking order
C) New equity issues are a last resort when company runs out of debt capacity
D) Leverage is preferred since it induces financial discipline on managers
D) Leverage is preferred since it induces financial discipline on managers
Rank the following financing options according to the pecking-order theory (1 = preferred)
A) Internal finds (retained earnings)
B) New debt issues
C) New equity issues
A) Internal finds (retained earnings) = 1
B) New debt issues = 2
C) New equity issues = 3
Asymmetric information affects the choice between internal and external financing and between new issues of debt and equity securities. This leads to a pecking order, in which investment is financed first with internal funds (reinvested earnings primarily), then by new issues of debt, and finally with new issues of equity.
New equity issues are a last resort when the company runs out of debt capacity.
The pecking order explains why the most profitable firms generally borrow less—not because they have low target debt ratios but because they don’t need outside money. Less profitable firms issue debt because they do not have internal funds sufficient for their capital investment programs and because debt financing is first on the pecking order of external financing.
True/ False
True
In the pecking-order theory, the attraction of interest tax shields is assumed to be first-order (priority).
True/ False
False
In the pecking-order theory, the attraction of interest tax shields is assumed to be second-order.
Which of the following statements hold true for Jensen’s Free Cash Flow Theory?
A) Financing decisions change managers’ incentives and capital budgeting and operating decisions
B) Managers tend to ample FCF/ excess financial slack to plow too much cash into ill-advised investments
C) Debt creates scheduled interest and principal payments, forcing the firm to pay out cash, leaving room for fewer investments
D) Debt can discipline managers who are tempted to invest too much
E) Debt provides pressure to force improvements in operating efficiency
F) Agency costs and conflict of interest is present
All are true
Define an arbitrage opportunity
Arbitrage opportunity: an opportunity to realize a guaranteed positive payoff with no risk of negative payoff at no net investment (self-financed opportunity)
MM’s proposition 1 states that the market value of any firm is independent of its capital structure
True/ False
True
Which of the following is NOT an assumption of Modigliani and Miller (1958) proposition 1?
A) Complete rationality
B) No transaction costs
C) No taxes
D) No bankruptcy or legal costs
E) Symmetric information - no signaling opportunities
F) No conflicts of interest
G) Complete markets - no financial innovation
H) Fixed investment policy (asset side of B/S is fixed)
I) Dividend policy is important
Wrong: I) Dividend policy is important
MM1 assumes dividend policy irrelevance
Following MM1 (the arbitrage proof), the value of levered firm is ____ value of unlevered firm
A) >
B) =
C) <
Following MM1 (the arbitrage proof), the value of levered firm is = value of unlevered firm
Following Michael Jensen, in a perfect capital market, the market value of a firm is independent of the proportion of debt financing, provided that the asset side (assets in place and growth opportunities) is held constant
True/ False
False: this is the case for the MM1
