Chapter 16: Debt Policy / Capital Structure

Question 1

What is capital structure?

Answer 1

The mix of long-term debt and equity financing.

Question 2

What is restructuring?

Answer 2

Process of changing the firm’s capital structure without changing its real assets.

Question 3

What is MM’s Proposition I (Debt-Irrelevance Proposition)?

Answer 3

Under idealised conditions the value of a firm is unaffected by its capital structure.

Question 4

What is operating risk (business risk)?

Answer 4

Risk in firm’s operating income.

Debt finance does not affect operating risk but it does add financial risk.

Question 5

What is financial leverage?

Answer 5

Debt financing. Leverage amplifies the effects of changes in operating income on the returns to stockholders.

Question 6

What is financial risk?

Answer 6

Risk to shareholders resulting from the use of debt.

Debt finance does not affect operating risk but it does add financial risk.

Question 7

What is MM’s Proposition II?

Answer 7

The required rate of return on equity increases as the firm’s debt-equity ratio increases.

Question 8

What is an interest tax shield?

Answer 8

Tax savings resulting from deductibility of interest payments.

Question 9

What is cost of financial distress?

Answer 9

Costs arising from bankruptcy or distorted business decisions before bankruptcy.

Question 10

What is trade-off theory?

Answer 10

Debt levels are chosen to balance interest tax shields against the costs of financial distress. This 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 poss financial distress. Firms with safe, tangible assets and plenty of taxable income should operate at high debt levels. Less profitable firms, or firms with risky, intangible assets ought to borrow less.

Question 11

What is risk shifting?

Answer 11

Firms threatened with default are tempted to shift to riskier investments.

Question 12

What is debt overhang?

Answer 12

Firms threatened with default may pass up positive-NPV projects because bondholders capture part of the value added.

Question 13

What is loan convenant?

Answer 13

An agreement between firm and lender requiring the firm to fulfil certain conditions to safeguard the loan.

Question 14

What is pecking order theory?

Answer 14

Firms prefer to issue debt rather than equity if internal finance is insufficient. Financial managers should try to maintain at least some financial slack (a reserve of ready cash or unused borrowing capacity). Careful: too much slack can make for poor management. High debt incentivises managers to work hard, conserve cash, avoid negative NPV investments.

Internal finance (i.e. earnings retained and reinvested) should come first, then choose debt.

Question 15

What is the goal of capital structure decisions?

Answer 15

The goal is to maximise the overall market value of all the securities issued by the firm.

Question 16

What is the financial manager trying to do when making a capital structure decision?

Answer 16

Think of the financial manager as 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 maximises the mkt val of the firm. If firm val increases, common stockholders will benefit.

Question 17

When does capital structure not matter?

Answer 17

MM’s famous debt-irrelevance proposition (Prop I) states that firm val 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 s/h but the risk of their shares inc proportionally. MM show that the extra return and extra risk balance out, leaving s/h no better or worse off. Remember, this is based on simplifying assumptions: efficient, well-functioning capital mkts, no tax, and no costs associated with financ. distress. But even if assumptions are not poss in practice, the prop still exposes logical traps particularly that debt is ‘cheap financing’ because the explicit cost of debt (the interest rate) is less than the cost of equity. Debt has a cost too, because borrowing incr fin risk and the cost of equity. When no corporate inc tax exists, MM show the WACC does not depend on the amt of debt financing.

Question 18

How do corporate income taxes modify MM’s leverage-irrelevance proposition?

Answer 18

Debt interest is a tax-deductible expense. Thus borrowing creates an interest tax shield. The PV of future interest tax shields can be large, a sign. fraction of the val of outstanding debt. Int tax shields are valuable only for companies that are making profits and paying taxes.

Question 19

If interest tax shields are valuable, why don’t all taxpaying firms borrow as much as poss?

Answer 19

The more firms borrow, the higher the odds of financ. distress.

Question 20

What are the costs of financial distress?

Answer 20

• Direct bankruptcy costs, L&A
• Indirect bankruptcy costs, hard to manage a company in distress
• Financial decisions that are distorted by the threat of default and bankruptcy, poor and risk investments (risk-shifting, debt-overhang)

Question 21

What is the formula for return on equity?

Answer 21

r(equity) = r(assets) + [D/E][r(assets) - r(debts)]

Note: r(equity) = r(assets) if the firm has no debt.

Question 22

What is the formula for WACC?

Answer 22

=D/V x (1-T(C))r(debt) + E/V x r(equity)