Debt Policy Flashcards
What is the capital structure of a firm and what is financial leverage/gearing?
Leverage/gearing refers to the use of borrowed funds to finance the acquisition of assets, with the aim of increasing the potential return on investment. Part of of investment financed by debt.
Capital structure is a firms mix of debt and equity finance.
What is the law of one price?
In perfect markets, two investments that offer same payoff/return (percentage of profits) must have same price.
What is MM proposition I?
Market value of firm and therefore shareholder wealth is independent of capital structure.
Firms should focus on investing in positive net present value (NPV) projects to increase valuation, as investment decisions are the primary driver of firm value according to MM.
What are the key assumptions of the MM theorem regarding capital structure?
No taxes.
No transaction or bankruptcy costs.
Symmetric information.
Competitive and efficient markets (perfect).
What is the Weighted Average Cost of Capital (WACC)?
The amount of money it must pay to finance its operations
How does a financial manager use WACC in capital structure decisions?
Financial managers aim to minimize WACC to maximize firm value, since a lower WACC reduces the overall cost of financing and increases the present value of future cash flows.
What is MM’s proposition II?
Rate of return they can expect to receive on their shares increase as firm’s debt-equity ratio (leverage) increases.
How does leverage affect the cost of equity?
As a firm increases its leverage (debt-to-equity ratio), the risk to equity holders increases. This higher financial risk leads investors to demand a higher return on their equity investment, resulting in an increase in the cost of equity.
What does MM Proposition II state about the relationship between leverage and the cost of equity?
The cost of equity increases linearly with leverage. In other words, as the firm increases its reliance on debt financing, the cost of equity also increases proportionately.
How do MM Propositions I and II combine?
MM Proposition II builds upon MM Proposition I by explaining how changes in the firm’s capital structure (leverage) affect the cost of equity.
Proposition I establishes that capital structure is irrelevant to firm value in perfect markets, while Proposition II demonstrates that, although capital structure doesn’t affect firm value, it does impact the cost of equity.
How can financial managers utilize MM Propositions I and II in practice?
While Proposition I suggests that capital structure itself doesn’t impact firm value, Proposition II shows that it affects the cost of equity.
Managers can adjust the firm’s leverage to achieve an optimal balance between tax benefits of debt and the increased cost of equity.
What does increased cost of equity mean for firms?
An increased cost of equity implies that firms must pay a higher rate of return to their equity investors.
What are the implications of a higher cost of equity on investment projects?
A higher cost of equity increases the required rate of return for investment projects.
This means that projects with lower expected returns may be deemed unprofitable or may require higher returns to be considered viable.
Potentially leading to a more stringent investment selection process.
How does an increased cost of equity impact the firm’s valuation?
A higher cost of equity leads to a lower valuation for the firm. This is because the cost of equity is used to discount future cash flows in valuation models.
A higher discount rate results in lower present values of future cash flows, reducing the firm’s overall value.
How does an increased cost of equity affect the firm’s competitiveness?
A higher cost of equity can make it more challenging for the firm to compete, especially against firms with lower costs of capital.
This may affect the firm’s ability to attract investors, raise capital, and pursue growth opportunities.
