Chapter 16 - Capital Structure Flashcards
What is the primary goal of financial managers?
How does choosing the correct capital structure effect this goal?
> Maximize stockholder wealth
> We want to choose the capital structure that will maximize stockholder wealth
What is the relationship between firm value and WACC?
We can maximize stockholder wealth by maximizing firm value or minimizing WACC (weighted average cost of capital)
> the value of the firm is maximized when WACC is minimized
What is the optimal Capital Structure?
A particular debt-equity ratio that results in the lowest WACC. Sometimes called the firms target capital structure
What is the impact of financial leverage on shareholders?
if we increase the amount of debt in a restructuring, we increase the fixed interest expense. But we are also decreasing the amount of outstanding shares.
Therefore If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders
If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders
What is homemade leverage?
The choice of capital structure is irrelevant if the investor can duplicate the cash flows on their own through personal borrowing
We are still ignoring taxes and transaction costs. If we factor in these market imperfections, then homemade leverage will not work quite as easily, but the general idea is the same.
What does M&M proposition I state?
That it is completely irrelevant how a firm chooses to manage its finances.
The value of the firm is NOT affected by changes in the capital structure
The cash flows of the firm do not change, therefore value doesn’t change
Aka: the size of the pie does not depend on how it is sliced
What does M&M proposition II state?
A firms cost of equity capital is a positive linear function of its capital structure
What are the two determinants of a firms cost of equity?
s
The total systematic risk of a firms equity has two parts. What are they?
d
What is the relationship between the value of an unlevered firm and a levered firm once we consider the effect of corporate taxes?
s
If we consider only the effect of taxes what is the optimal capital structure?
s
What are direct bankruptcy costs?
s
What are indirect bankruptcy costs?
s
What are the agency costs of equity?
s
Describe the trade-off that defines the static theory of capital structure
s
