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Debt Policy and Capital Structure Flashcards

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
what is a distorted business decision
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
26
what does the optimal level of debt for a firm depend on (trade off theory)
volatility of cashflows
27
a firm with more stable cash flows might want to choose more or less debt
more
28
what do the costs of actual bankruptcy include
lawyers | fire sale of assets
29
what does fire sale of assets mean
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
what is the pecking order theory
firms prefer to issue debt rather than equity if internal finance is sufficient
31
what is the order in which firms prefer to finance
internal funding -> debt -> equity
32
how do public companies close the gap of asymmetric information
publishing their accounts
33
what is assymetric information
when the firm knows more about their decisions than their investors keeping matters internal to the firm
34
when should a firm issue equity ideally
when they think the value of their compnay is overpriced ie before the price drops so they can get the most money
35
what do investors think if the firm issues shares when the equity is underpriced
that the firm is in trouble that the managers must think that this is the equity overpriced that they want to sell
36
what type of financing takes the least negative signals
reinvesting retained earnings
37
which companies might the pecking order theory might not be relevant for
those with no internal funds those with no ability to borrow
38
what type of firms is the pecking order theory most relevant for
older and mature firms
39
what are some other factors not mentioned in the theories that companies will take into account when choosing debt policies
tax advantages of debt need to maintain good credit ratings need for financial flexibility leverage for similar sized firms
40
what is financial slack
ready access to cash or debt financing
41
benefits of more financial slack
management has access to cash more quickly
42
what type of firms is financial slack more important in
value adding firms
43
where does long run value rest more in
capital investments
44
drawbacks of too much financial slakc
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
cashflows of liability payments should match WHAT as closely as possible
cashflows of assets
46
when debt is raised, the maturity should match what
asset maturity don't want to be raising new debt to pay off old debt
47
what should be considered when raising debt
debt and asset maturity fixed vs floating rate currency of debt instruments
48
things to consider when deciding on capital structure
- 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
which types of firms does the trade off theory apply most to
older, mature firms who have both the option of dipping into their own funds and borrowing
50
what type of firms is the trade off theory not really relevant for
smaller, newer firms those that may not have enough retained funds, cannot raise equity easily or cannot borrow
51
formula for the effective tax advantage of debt ie after personal taxes
1 - (((1-corp tax)(1-income tax))/(1-tax on interest income)
52
what is the optimal level of leverage from a tax savings perspective
the level such that interest on debt is equal to earnings before interest and tax
53
what is financial distress
when a firm has difficulty meeting its debt obligations
54
what is a default
when a firm fails to make the required interest or principal payments on its debt
55
two forms of bankruptcy protection in US
Chapter 7 - Liquidation Chapter 11 - Reorganisation
56
what is chapter 7 liquidation
firms assets are liquidised proceeds used to pay the firms creditors after the firm ceases to exist
57
what is chapter 11 reorganisation
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
direct costs of bannkrupcy
fire sale of assets legal costs/hiring outside experts
59
indirect costs of bankrupcy
loss of customers loss of suppliers loss of employees, difficulty hiring new employees loss of receivables costs to creditors
60
what is the value of a levered firm according to the trade off theory
V_L = V_U + PV(Interest Tax Shield) - PV(Financial Distress Cost)
61
what effects the probability of financial distress
amount of a firm's liabilities relative to assets volatility of cash flows and asset values
62
how does financial distress cost vary by industry
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
is the present value of distress costs higher for higher or lower beta firms
higher beta firms
64
what is a debt covenant
agreements between a company and its lenders that the company will operated within certain rules set by the ledners
65
what is the effect of concentration and ownership
using leverage preserves ownership
66
what is the free cash flow hypothesis
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
what is the formula for the value of the firm after tax, financial distress costs and agency costs/benefits
V_L = V_U + PV(interest tax shield) - PV(financial distress costs) - PV(Agency costs) + PV(agency benefits)
68
how can issuing debt be a form of signalling
firm has a large new profitable project, commits to debt expects they will have no trouble repaying
69
lemon's principle for equity
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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