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.
What does the M&M Proposition 2 tell us?
The return on equity is equal to the return on assets plus a premium to compensate for the financial risk caused by leverage.
What happens when we apply the CAPM on Proposition 2?
We obtain an equivalent relation for betas.
True or false: the higher the leverage, the risker the equity.
True
Is holding excess cash part of the financing decision?
Yes.
What is excessive cash?
Excessive cash is cash and short-term investments that aren’t used in the company’s operations.
True or false: M&M Proposition 2 tells us that the systematic risk of equity increases with leverage.
True
Why does systematic risk of equity increases with leverage?
- debt carries less systematic risk than equity
- fewer shareholders are carrying the same asset risk that would be shared by more equityholders if the firm was all-equity financed
What is riskless debt?
cash flows are always higher than the promised payment on debt in all realisations of the future
What is risky debt?
there is at least one realisation of the future where cash flows are lower than the promised payment on debt
When we have risky debt, does the value of the assets and the opportunity cost of capital change?
Not under perfect market conditions
If debt is risky, does the equity cost of capital increase?
Yes
True or false: the WACC changes for alternative capital structures
False
In perfect capital markets, is WACC equal to the asset cost of capital?
Yes
What drives the riskiness of securites?
The riskiness of assets
Does the riskiness of securities drive the riskiness of assets?
No, it’s the other way around.
If the firm is all-equity financed is the beta from equity equal to the beta from assets?
Yes
When does rA change?
taxes
How do you calculate wealth?
wealth = P + DPS
If debt is risk free what is the value of debt’s beta?
0
Does P change when you repurchase stock?
no
