Chapter 17 Flashcards
What is debt consolidation?
Reducing the number of creditors to minimize contracting and monitoring costs.
What causes firms to avoid issuing equity according to pecking order theory?
It may signal to the market that the stock is overvalued.
What is a firm’s target capital structure?
The optimal mix of debt and equity that balances costs and benefits of financing.
What does the pecking order theory imply about target debt ratios?
Firms don’t have a strict target; financing decisions depend on internal resources and market conditions.
What happens to firm value when leverage increases?
It may increase if tax benefits outweigh distress costs, as suggested by M&M with taxes.
What are indirect costs of financial distress?
Impaired ability to conduct business and agency costs like underinvestment or excessive risk-taking.
Give examples of protective covenants.
Limits on dividends, restrictions on additional debt, and requirements to maintain financial ratios.
What is financial distress?
A situation where a firm cannot meet its debt obligations, possibly leading to bankruptcy.
Why might profitable firms borrow very little?
They rely on internal financing and prefer to avoid distress or signaling costs.
What happens to bondholders in liquidation when firm value falls below debt value?
Bondholders take a loss, and equity holders typically receive nothing.
Why is financial slack considered valuable?
It provides flexibility and reduces reliance on costly or risky financing.
How do leverage changes affect stock prices?
Increases in leverage may signal confidence and raise stock price; decreases may signal weakness.
What are direct costs of financial distress?
Legal and administrative costs related to bankruptcy.
Why might a firm not issue equity even if it needs funds?
To avoid negative market reactions due to asymmetric information.
What is Selfish Strategy 3 in financial distress?
Milking the property—paying large dividends or perks to shareholders, leaving less for creditors.
What is the main purpose of setting limits on dividends in protective covenants?
To preserve cash for debt repayment and reduce default risk.
How does operating income uncertainty impact debt usage?
High uncertainty increases the likelihood of financial distress, so firms borrow less.
According to trade-off theory, when is debt more favorable?
For firms with stable cash flows and tangible assets that can serve as collateral.
What are protective covenants?
Restrictions placed by lenders to limit risky actions by borrowers and reduce financial distress costs.
What is Selfish Strategy 2 in financial distress?
Underinvestment, where shareholders avoid funding positive NPV projects to protect their own interests.
What is the trade-off theory of capital structure?
Firms balance the tax benefits of debt with the potential costs of financial distress.
What is the relationship between market-to-book ratio and debt usage?
Firms with high market-to-book ratios tend to use less debt.
What is asymmetric information in capital structure?
Managers know more about the firm’s true value than outside investors.
What is the pecking order theory?
Firms prefer internal financing first, then debt, and issue equity only as a last resort.
What does empirical evidence show about capital structure?
Firms act as if they have target debt ratios, influenced by both trade-off and pecking order theories.
Why do firms sometimes avoid tax benefits of debt?
Due to concerns over financial distress, flexibility, or future financing needs.
How do agency costs relate to capital structure?
They arise when managers take actions that benefit shareholders at the expense of debt holders.
What is financial slack?
A firm’s ability to fund investments without external financing.
Why do firms with tangible assets tend to borrow more?
Tangible assets serve as better collateral, reducing the risk to lenders.
Why do firms with volatile earnings use less debt?
They are more likely to face financial distress and may struggle to meet fixed debt payments.
What are common factors in a firm’s target debt/equity ratio?
Taxes, asset types, operating income uncertainty, and financial slack.
What does the WACC framework imply about changes in capital structure?
Changes in the debt/equity mix can affect the firm’s overall cost of capital and valuation.
What does Chapter 11 bankruptcy involve?
Reorganization of the firm to continue operating while repaying debts.
What is Selfish Strategy 1 in financial distress?
Taking high-risk gambles that benefit shareholders but hurt bondholders.
What does Chapter 7 bankruptcy involve?
Liquidation of the firm’s assets to pay creditors.
What role does financial flexibility play in capital structure decisions?
It allows firms to act quickly on opportunities or survive downturns without needing external financing.
What is the signaling theory in capital structure?
Firms use capital structure changes to convey private information to the market.
How do industry norms influence capital structure?
Firms often align their debt ratios with others in their industry for benchmarking and competitive consistency.
How does profitability affect borrowing according to pecking order theory?
More profitable firms borrow less because they rely more on internal funds.
How does size influence capital structure decisions?
Larger firms tend to have higher debt ratios due to easier access to debt markets.
