Corp 3 Flashcards
What is the main goal of financial managers regarding debt and equity financing?
To find the combination of debt and equity financing that maximizes the total value of the firm.
Define levered equity.
The equity (ownership interest) of a firm that has debt in its capital structure.
What is unlevered equity?
The equity of a firm that has no debt in its capital structure.
What does Modigliani and Miller’s Proposition 1 state?
The market value of a company does not depend on its capital structure.
List the assumptions of Modigliani and Miller Proposition 1.
- No taxes
- No bankruptcy costs
- No effect on management incentives.
What is the implication of the interest tax shield?
It increases the total income that can be paid out to bondholders and stockholders.
What does Modigliani and Miller’s Proposition II explain?
The expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity ratio.
True or False: Financial leverage affects the risk or expected return on the firm’s assets.
False.
What are the direct and indirect costs of financial distress?
- Direct costs include bankruptcy costs
- Indirect costs include lost customers and suppliers.
What is the trade-off theory of capital structure?
It suggests that firms balance the tax benefits of debt with the costs of financial distress.
Fill in the blank: The _____ theory of financing suggests that firms prefer internal financing over external financing.
pecking order.
What happens to equity earnings when a firm has 50% debt in its capital structure?
Compared to an all-equity-financed situation, the return on equity doubles.
What is the impact of leverage on expected returns according to MM’s Proposition 2?
Leverage increases the expected stream of earnings per share but not the share price.
Define the concept of financial slack.
The availability of excess cash or liquid assets that a firm can use for unexpected expenses or opportunities.
What is meant by the agency costs of financial distress?
Costs that arise from conflicts of interest between shareholders and debtholders during financial distress.
How does high debt influence a firm’s risk appetite?
High debt reduces firms’ appetites for business risk.
List the components of the indirect cost of financial distress.
- Customers worry about resale value
- Suppliers may demand cash upfront
- Potential employees are less willing to join.
What is the primary conclusion of MM’s Proposition 1 regarding asset value?
The value of an asset is preserved regardless of the nature of the claims against it.
True or False: The change in the expected earnings stream is exactly offset by a change in the rate at which the earnings are discounted.
True.
What does the corporate tax shield refer to?
The reduction in tax liability due to the deductibility of interest payments.
What is the effect of personal taxes on the relative tax advantage of debt?
Interest income is taxed at a higher rate than equity income, reducing the tax advantage of debt.
Define the pecking order theory in capital structure.
A theory that suggests firms prefer internal financing first, then debt, and issue equity as a last resort.
What does a good NPV project imply for a firm’s assets?
The firm’s assets include a new, safe asset worth $15
A good NPV project indicates positive value creation for the firm.
How does a good NPV project affect the market value of bonds?
The probability of default is less, market value of bond increases
Lower default risk generally leads to higher bond prices.
If a firm gains $15 in assets but has a debt of $8, what is the equity value increase?
$15 - $8 = $7
This demonstrates how debt impacts equity value increases.
What does the term ‘Cash in and Run’ refer to in finance?
Refusing to contribute equity capital and taking money out
This strategy can indicate financial distress or opportunistic behavior.
What are ‘delay tactics’ that stockholders might use?
Misreporting, earnings management to hide the true status of financial performance
These tactics can be used to avoid immediate financial obligations.
Define the Trade-Off Theory of Capital Structure.
Capital structure is based on trade-off between tax savings and distress costs of debt
This theory helps firms balance the benefits of debt against its risks.
What does the formula for the value of the firm include?
Value if all-equity-financed + PV(Tax shield) - PV(cost of financial distress)
This formula highlights the components that contribute to a firm’s value.
What is the Pecking Order Theory?
Firms prefer to issue debt over equity if internal finances are insufficient
This theory emphasizes the hierarchy of financing preferences.
What is a key implication of the Pecking Order Theory regarding dividend policies?
Adapt target dividend payout ratios to investment opportunities while avoiding changes in dividends
This helps maintain investor confidence and financial stability.
What does ‘Financial Slack’ refer to?
Read access to cash or debt financing
Financial slack provides firms with flexibility in funding opportunities.
What is the relationship between financial slack and positive-NPV growth opportunities?
Financial slack is most valuable to firms with plenty of positive-NPV growth opportunities
It allows firms to invest in profitable projects without immediate external financing.
What is the free-cash-flow problem?
The principal-agent problem between shareholders and management
This issue can lead to inefficiencies in firm management.
How do large firms typically compare in terms of debt ratios?
Large firms tend to have higher debt ratios
Size can influence a firm’s ability to manage and sustain debt.
What is the relationship between tangible assets and debt ratios?
Firms with high ratios of fixed assets to total assets have higher debt ratios
Tangible assets often serve as collateral for debt.
What is the implication of a high market-to-book ratio on debt ratios?
Firms with higher ratios of market-to-book value have lower debt ratios
This indicates a preference for equity financing over debt.
How does profitability affect debt ratios?
More profitable firms have lower debt ratios
Profitability provides firms with internal funds, reducing the need for debt.
