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Finance > Debt Policy and Capital Structure > Flashcards

Debt Policy and Capital Structure Flashcards

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1
Q

what is capital structure

A

the firm’s mixture of debt and equity

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2
Q

what is business risk

A

the equity risk that coms from the firm’s operating activities

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3
Q

what is financial risk

A

the equity risk that coms from the capital structure of the frim

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4
Q

what does leverage or gearing mean

A

financing investments with debt

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5
Q

does leverage minimise or magnify gains and losses

A

magnify

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6
Q

what are the three capital structure theories

A

modigliani and miller
trade off theory
pecking order theory

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7
Q

what do modigliani and miller first propose

A

that when there are no taxes, no bankruptcy costs and efficient capital markets, the market value of a company is indepent of its capital structure

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8
Q

what is unrealistic about the modigliani miller thoery

A

no taxes

no bankruptcy

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9
Q

what is the implicit cost of debt

A

the extra demand required from shareholders due to the risk of debt - they are last in the payments hierarchy

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10
Q

what is modigliani and millers second propostition

A

the rquired rate of return on equity in a leverages firm increases the proportion to the firm’s debt-equity ratio and the overall cost of capital remains unchanges

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11
Q

what is the tax shield

A

reduction in tax costs

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12
Q

M&M proposition 1 with taxes

A

V_L = V_U + T_c.D

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13
Q

what is a leveraged investment

A

if you borrow to invest

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14
Q

examples of very common forms of leveraged investments

A

mortgages

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15
Q

what is the most amount you can lose on an investment if you have no leverage

A

what you initially invested

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16
Q

what is the first M&M proposition

A

that the choice of capital structure is irrelevant for maximising the value of the firm. The value of the firm is determined by the assets

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17
Q

what are costs of financial distress

A

costs that come along with bankruptcy for example lawyers

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18
Q

how does the M&M theory change with the introduction of taxes

A
  • value of firm with and without leverage is not equal when you take tax shields into account

therefore, you should have the highest possible proportion of debt, 99.9%

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19
Q

how does the tax shield change as the proportion of debt increases

A

it also increases

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20
Q

what does the trade off theory propose

A

that the capital structure is based on a trade-off between tax savings and distress cost of debt

the firm borrows up to the point where the tax benefit from an extra euro of debt is exactly equal to the cost that comes from the increased financial distress

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21
Q

what are the distress costs on clients

A

might not get paud

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22
Q

what is the distress cost on customer

A

might not get the products they’ve ordered

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23
Q

what are the distress costs to the investors

A

might not get back 100% of the money they lent

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24
Q

what is the distress costs to the managers

A

take distorted business decisions

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25
Q

what is a distorted business decision

A

when a manager may throw money at investments they may not have otherwise, they are less risk averse than they should be, knowing they are close to bankruptcy or in trouble

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26
Q

what does the optimal level of debt for a firm depend on (trade off theory)

A

volatility of cashflows

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27
Q

a firm with more stable cash flows might want to choose more or less debt

A

more

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28
Q

what do the costs of actual bankruptcy include

A

lawyers

fire sale of assets

29
Q

what does fire sale of assets mean

A

you may be offered less for your assets than you would otherwise, as buyers are aware you’re trying to get rid of them

30
Q

what is the pecking order theory

A

firms prefer to issue debt rather than equity if internal finance is sufficient

31
Q

what is the order in which firms prefer to finance

A

internal funding -> debt -> equity

32
Q

how do public companies close the gap of asymmetric information

A

publishing their accounts

33
Q

what is assymetric information

A

when the firm knows more about their decisions than their investors
keeping matters internal to the firm

34
Q

when should a firm issue equity ideally

A

when they think the value of their compnay is overpriced ie before the price drops so they can get the most money

35
Q

what do investors think if the firm issues shares when the equity is underpriced

A

that the firm is in trouble

that the managers must think that this is the equity overpriced

that they want to sell

36
Q

what type of financing takes the least negative signals

A

reinvesting retained earnings

37
Q

which companies might the pecking order theory might not be relevant for

A

those with no internal funds

those with no ability to borrow

38
Q

what type of firms is the pecking order theory most relevant for

A

older and mature firms

39
Q

what are some other factors not mentioned in the theories that companies will take into account when choosing debt policies

A

tax advantages of debt
need to maintain good credit ratings
need for financial flexibility
leverage for similar sized firms

40
Q

what is financial slack

A

ready access to cash or debt financing

41
Q

benefits of more financial slack

A

management has access to cash more quickly

42
Q

what type of firms is financial slack more important in

A

value adding firms

43
Q

where does long run value rest more in

A

capital investments

44
Q

drawbacks of too much financial slakc

A

can lead to lazy management eg outsourcing, embezzled accounts

mnagers could try to increase their own slalries or engage in empire building, to say they’re the CEO of such and such public firm

45
Q

cashflows of liability payments should match WHAT as closely as possible

A

cashflows of assets

46
Q

when debt is raised, the maturity should match what

A

asset maturity

don’t want to be raising new debt to pay off old debt

47
Q

what should be considered when raising debt

A

debt and asset maturity
fixed vs floating rate
currency of debt instruments

48
Q

things to consider when deciding on capital structure

A
  • volatility of cash flows (depends on maturity of the firm)
  • think of cushion equity provides
  • tax rates makes debt cheaper
  • cost of funding debt
49
Q

which types of firms does the trade off theory apply most to

A

older, mature firms who have both the option of dipping into their own funds and borrowing

50
Q

what type of firms is the trade off theory not really relevant for

A

smaller, newer firms

those that may not have enough retained funds, cannot raise equity easily or cannot borrow

51
Q

formula for the effective tax advantage of debt ie after personal taxes

A

1 - (((1-corp tax)(1-income tax))/(1-tax on interest income)

52
Q

what is the optimal level of leverage from a tax savings perspective

A

the level such that interest on debt is equal to earnings before interest and tax

53
Q

what is financial distress

A

when a firm has difficulty meeting its debt obligations

54
Q

what is a default

A

when a firm fails to make the required interest or principal payments on its debt

55
Q

two forms of bankruptcy protection in US

A

Chapter 7 - Liquidation

Chapter 11 - Reorganisation

56
Q

what is chapter 7 liquidation

A

firms assets are liquidised

proceeds used to pay the firms creditors

after the firm ceases to exist

57
Q

what is chapter 11 reorganisation

A

creditors may receive cash payments and/or new debt or equity structures of the firm

the value of these payments is less than what they were owed but more than what they would have received if the firm had been liquidated

creditors must vote to accept the plan

58
Q

direct costs of bannkrupcy

A

fire sale of assets

legal costs/hiring outside experts

59
Q

indirect costs of bankrupcy

A

loss of customers
loss of suppliers
loss of employees, difficulty hiring new employees
loss of receivables

costs to creditors

60
Q

what is the value of a levered firm according to the trade off theory

A

V_L = V_U + PV(Interest Tax Shield) - PV(Financial Distress Cost)

61
Q

what effects the probability of financial distress

A

amount of a firm’s liabilities relative to assets

volatility of cash flows and asset values

62
Q

how does financial distress cost vary by industry

A

technology firms will have higher costs due to loss of customers and key personnel as well as lack of tangible assets that can be easily liquidated

real estate firms are likely to have lower financial distress costs because their assets are tangible and can be sold relatively easilt

63
Q

is the present value of distress costs higher for higher or lower beta firms

A

higher beta firms

64
Q

what is a debt covenant

A

agreements between a company and its lenders that the company will operated within certain rules set by the ledners

65
Q

what is the effect of concentration and ownership

A

using leverage preserves ownership

66
Q

what is the free cash flow hypothesis

A

wasteful spending is more likely to occur when firms have high levels of cash flow in excess of what is needed after making all positive NPV investments and payments to debt holders

where as when cash is tight, managers will be motivated to run the firm as efficiently as possible

leverage increases firm value because more payments must be made

67
Q

what is the formula for the value of the firm after tax, financial distress costs and agency costs/benefits

A

V_L = V_U + PV(interest tax shield) - PV(financial distress costs) - PV(Agency costs) + PV(agency benefits)

68
Q

how can issuing debt be a form of signalling

A

firm has a large new profitable project, commits to debt

expects they will have no trouble repaying

69
Q

lemon’s principle for equity

A

owner of shares offers to sell shares

buyers suspect he is trying to sell out before negative information becomes public

buyers will only buy the equity at heavily discounted prices

owners of shares who know equity has good prospects won’t sell as they have high value

Finance (12 decks)

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