Chapter 16-17 Flashcards
What is the goal of the capital structure decision? What is the financial manager trying to do? When would capital structure not matter?
- To maximize the overall market value of all the securities issued by the firm.
Financial manager: taking all the firm’s real assets and selling them to investors as a package of securities. Some financial managers choose the simplest package possible: all-equity financing. Others end up issuing dozens of types of debt and equity securities. The financial manager must try to find the particular combination that maximizes the market value of the firm. If firm value increases, common stockholders will benefit.
How do corporate income taxes modify MM’s leverage-irrelevance proposition?
Debt interest is a tax-deductible expense. Thus borrowing creates an interest tax shield. The present value of future interest tax shields can be very large, a substantial fraction of the value of outstanding debt. Of course, interest tax shields are valuable only for companies that are making profits and paying taxes.
If interest tax shields are valuable, why don’t all taxpaying firms borrow as much as possible?
The more firms borrow, the higher the odds of financial distress. The costs of financial distress can be broken down as follows:
∙ Direct bankruptcy costs, primarily legal and administrative costs.
∙ Indirect bankruptcy costs, reflecting the difficulty of managing a company when it is in bankruptcy proceedings.
∙ Financial decisions that are distorted by the threat of default and bankruptcy, including poor investment decisions caused by the conflicts of interest between debtholders and stockholders. These conflicts create potential risk-shifting and debt-overhang problems.
What’s the pecking order theory?
The pecking order theory says that firms prefer internal financing (i.e., earnings retained and reinvested) over external financing. If external financing is needed, they prefer to issue debt rather than issue new shares. The pecking order theory says that the amount of debt a firm issues will depend on its need for external financing. The theory also suggests that financial managers should try to maintain at least some financial slack, that is, a reserve of ready cash or unused borrowing capacity
On the other hand, too much financial slack may lead to slack managers. High debt levels (and the threat of financial distress) can create strong incentives for managers to work harder, conserve cash, and avoid negative-NPV investments.
Is there a rule for finding optimal capital structure?
No, there are no simple answers for capital structure decisions. Debt may be better than equity in some cases, worse in others.
How are dividends paid, and how do companies decide how much to pay?
Dividends come in many forms. The most common is the regular cash dividend, but sometimes companies pay a stock dividend. A firm is not free to pay dividends at will. For example, it may have accepted restrictions on dividends as a condition for borrowing money.
Dividends do not go up and down with every change in the firm’s earnings. Instead, managers aim for smooth dividends and increase dividends gradually as earnings grow.
How are repurchases used to distribute cash to shareholders?
Corporations also distribute cash by repurchasing shares. Stock repurchases have grown rapidly in recent years, but they do not always replace dividends. Mature firms that pay dividends also repurchase shares. On the other hand, thousands of U.S. corporations pay no dividends at all. When they pay out cash, they do so exclusively through repurchases.
Why are dividend increases and repurchases usually good news for investors?
Managers do not increase dividends unless they are confident that the firm will generate enough earnings to cover the payout. Therefore, announcement of a dividend conveys the managers’ confidence to investors.
Repurchases are usually also good news. For example, announcement of a repurchase program can reveal managers’ view that their company’s stock is a “good buy” at the current price.
Cash payouts by dividends and repurchases can also reassure investors who worry that managers might otherwise spend the money on empire-building and negative-NPV projects.
Why would payout policy not affect firm value in an ideal world?
Payout policy is a trade-off between cash dividends and the issue or repurchase of common stock.
Assumption: holding the company’s investment policy and capital structure constant.
In an ideally simple and perfect world, the choice would have no effect on market value. An increased cash dividend would require more shares issued or fewer shares repurchased. The increased cash in shareholders’ wallets would be exactly offset by a lower share price. This is MM’s dividend-irrelevance proposition.
How might differences in the tax treatment of dividends and capital gains affect payout policy?
The investor pays no tax on capital gains until his or her shares are actually sold. The longer the wait before the sale, the lower the present value of the tax. Thus, capital gains have a tax advantage for investors.
If dividend income is taxed more heavily than capital gains, investors should shun high-dividend stocks. Instead of paying high dividends, corporations should shift to repurchases.
Does capital structure always affect firm value?
Capital structure does not necessarily affect firm value. Modigliani and Miller’s (MM’s) famous debt-irrelevance proposition states that firm value can’t be increased by changing capital structure. Therefore, the proportions of debt and equity financing don’t matter. Financial leverage does increase the expected rate of return to shareholders, but the risk of their shares increases proportionally. MM show that the extra return and extra risk balance out, leaving shareholders no better or worse off.
What are some assumptions, strengths and weaknesses with MM’s model?
MM’s argument rests on simplifying assumptions such as:
- Efficient, well-functioning capital markets
- Ignores taxes and costs of financial distress.
But even if these assumptions are incorrect in practice, MM’s proposition is important. It exposes logical traps that financial managers sometimes fall into, particularly the idea that debt is “cheap financing” because the explicit cost of debt (the interest rate) is less than the cost of equity. Debt has an implicit cost, too, because increased borrowing increases financial risk and the cost of equity. When both costs are considered, debt is not cheaper than equity. MM show that if there are no corporate income taxes, the firm’s weighted-average cost of capital does not depend on the amount of debt financing.
Why are dividend cuts bad news?
Dividend cuts convey lack of confidence. Managers generally avoid them unless their firms are in trouble. This information content of dividends is the main reason that stock prices respond to dividend changes.
What dimensions are important for a financial manager to think about?
There are at least four dimensions for the financial manager to think about.
∙ Taxes. How valuable are interest tax shields? Is the firm likely to continue paying taxes over the full life of a debt issue? Safe, consistently profitable firms are most likely to stay in a taxpaying position.
∙ Risk. Financial distress is costly even if the firm survives it. Other things equal, financial distress is more likely for firms with high business risk. That is why risky firms typically issue less debt.
∙ Asset type. If distress does occur, the costs are generally greatest for firms whose value depends on intangible assets. Such firms generally borrow less than firms with safe, tangible assets.
∙ Financial slack. How much is enough? More slack makes it easy to finance future investments, but it may weaken incentives for managers. More debt, and therefore less slack, increases the odds that the firm may have to issue stock to finance future investments.
What is the tradeoff theory between tax shields and costs of financial distress?
Combining interest tax shields and costs of financial distress leads to a trade-off theory of optimal capital structure. The trade-off theory says that financial managers should increase debt to the point where the value of additional interest tax shields is just offset by additional costs of possible financial distress.
The trade-off theory says that firms with safe, tangible assets and plenty of taxable income should operate at high debt levels. Less profitable firms, or firms with risky, intan- gible assets, ought to borrow less.
