Corporate Finance - Chp. 22: Capital Structure Flashcards
1
Q
MM Proposition I (no taxes):
A
- the capital structure irrelevance proposition
- Proved that the value of a firm is unaffected by its capital structure
- Value of leveraged firm = Value of unleveraged firm
- Assumptions
- Capitals markets are perfectly competitive
- Investors have homogeneous expectations
- Riskless borrowing and lending
- No agency costs
- Investment decisions are unaffected by financing decisions
2
Q
- MM Proposition II (no taxes): cost of equity and leverage proposition
A
- cost of equity and leverage proposition
- The cost of equity increases linearly as a company increases its proportion of debt financing. Split b/t debt and equity still does not affect value of firm.
Assumes perfect markets
o re=r0+D/E(r0– rd)
§ re = required rate of return on equity, or cost of equity
§ r0 = company unlevered cost of capital (i.e., assume no leverage)
§ rd = required rate of return on borrowings, or cost of debt
§ D/E = debt-to-equity ratio
3
Q
MM Prop I (with taxes):
A
- value is maximized at 100% debt
- Tax shield provided by debt
- Tax shield = marginal tax rate multiplied by amt of debt in capital structure
- Value of leveraged firm = value of unleveraged firm + tax shield
- VL = VU + (t × d)
- VL = value of levered firm
- VU = value of unlevered firm
- t = marginal tax rate
- d = value of debt in capital structure
*
- VL = VU + (t × d)
4
Q
MM Prop II (with taxes):
A
- WACC is minimized (value of firm is maximized) at 100% debt
- o rE= r0+D/E(1–TC)
§ TC = tax rate
5
Q
Costs of financial distress
A
- – increased costs a company faces when it is having hard time paying fixed financing costs (debt interest)
- Costs of financial distress and bankruptcy (direct and indirect)
- Probability of financial distress
6
Q
Agency costs of equity
A
- costs associated with the conflicts of interest between managers and owners
- Greater amounts of financial leverage tend to reduce agency costs
- Net agency cost of equity – result of equity owners taken steps to reduce this cost
- Monitoring costs – supervising management. Strong corporate governance reduces monitoring costs
- Bonding costs – assumed by management to assure shareholders best interests
- Residual losses – when monitoring and bonding costs still fail
7
Q
Costs of asymmetric info
A
- cost from managers having more info about a company’s future than owners or creditors. Firms with complex products or little transparency in financial statements tend to have higher costs of asymmetric info, results in higher required returns on debt and equity capital.
- Taking on debt shows confidence that the interest can be payed
- Issuing equity viewed as a negative signal that stock is believed overvalued
8
Q
- Pecking order theory
A
- Mgmt. tends to finance with capital least visible to investors
- Pecking order from most to least favored is:
- Internally generated equity
- Debt
- External equity
9
Q
- Static trade off theory
A
- Seeks to balance costs of financial distress with tax shield benefits from using debt
- Optimal capital structure that has optimal proportion of debt
- Point where WACC is minimized and value of firm maximized
- VL = VU + (t × d) – PV(costs of financial distress)
10
Q
- propositions Implications for managerial decision making
A
- MM’s propositions with no taxes – capital structure irrelevant
- MM’s propositions with taxes – WACC is minimized and firm value maximized at 100% debt
- Static trade off theory – recognize there are tax benefits to issuing debt, but increasing the use of debt also increases the cost of financial distress. Balance the benefits of debt with costs of distress for optimal structure.
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11
Q
Target capital structure
A
- structure the firm uses over time when making decisions about raising capital
- Fluctuates around optimal structure for two reasons
- Mgmt. may choose to exploit opportunities in a specific financing source
- Market fluctuations occur
- Fluctuates around optimal structure for two reasons
12
Q
international factors on debt
A
