Debt Flashcards
What is capital structure?
Capital structure is the proportion of debt, equity and other securities that a firm uses to finance its operations
What is debt?
The cash flows that are capped to the promised amounts
What are debtholders entitled to?
interest payments and the principal at maturity
Who has seniority on the firm’s cash flows?
debtholders
True or false: debtholders have voting rights.
False
What is equity?
The rights to the cash flows after debtholders are paid
True or false: equityholders have voting rights.
True
Who has ownership over the firm: debt or equityholders?
equityholders
Who has residual claimants of the firm’s cash flows?
equityholders
Who has limited liability?
equityholders, since shareholders aren’t personally liable if the firm goes bankrupt
What other examples besides debt and equity can be part a firm’s capital structure?
Warrants, convertible debt, leasing, hybrid securities, etc.
What does it mean when equity is unlevered?
There’s no debt D/E=0
What is the main conclusion of M&M?
Under perfect capital market conditions, the total value of a firm doesn’t depend on its capital structure.
Why is is that under perfect capital market conditions, the total value of a firm doesn’t depend on its capital structure?
Because total cash flows to the investor of the firm are equal to the cash flows that the project will generate, and therefore have the same present value.
What are the assumptions for M&M Proposition 1?
- investment policy is held constant
- no transaction costs
- capital markets are efficient
- managers maximise shareholder’s wealth
- no taxes
- no bankruptcy costs
What is the M&M Proposition 1?
Under perfect market condition a firm’s market value is independent of its capital structure.
What does “the size of the pie” depend on?
- operating policy by firm
- working capital policy
- investment policy
- business risk (and corresponding risk premium)
What can’t exist in perfect capital market?
Arbitrage opportunities
What is arbitrage?
Arbitrage consists of taking advantage of mispricing in the market and usually involves the simultaneous purchase and sale of securities that are supposed to have the same price to make a riskless profit. It has to have non-negative cash flows at all instances and at the very minimum, a non-zero probability of getting a positive cash-flow in at leat one moment in time.
What will result from the actions of arbitrageurs?
Their actions result in the price of the cheapest one to rise and the most expensive to fall, making the arbitrage opportunity to disappear.
What does leverage cause to equityholders?
It increases their risk and therefore the return they ask for increases to compensate for the extra risk.
Dow we need risky debt for leverage to increase the risk on equity?
No
Following M&M, what is the WACC equal to?
return on assets
Following M&M, does the WACC depend on the mix of securities the firm has outstanding?
No, WACC only depends on its assets and operating activities.
