Debt Policy and Capital Structure Flashcards
what is capital structure
the firm’s mixture of debt and equity
what is business risk
the equity risk that coms from the firm’s operating activities
what is financial risk
the equity risk that coms from the capital structure of the frim
what does leverage or gearing mean
financing investments with debt
does leverage minimise or magnify gains and losses
magnify
what are the three capital structure theories
modigliani and miller
trade off theory
pecking order theory
what do modigliani and miller first propose
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
what is unrealistic about the modigliani miller thoery
no taxes
no bankruptcy
what is the implicit cost of debt
the extra demand required from shareholders due to the risk of debt - they are last in the payments hierarchy
what is modigliani and millers second propostition
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
what is the tax shield
reduction in tax costs
M&M proposition 1 with taxes
V_L = V_U + T_c.D
what is a leveraged investment
if you borrow to invest
examples of very common forms of leveraged investments
mortgages
what is the most amount you can lose on an investment if you have no leverage
what you initially invested
what is the first M&M proposition
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
what are costs of financial distress
costs that come along with bankruptcy for example lawyers
how does the M&M theory change with the introduction of taxes
- 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%
how does the tax shield change as the proportion of debt increases
it also increases
what does the trade off theory propose
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
what are the distress costs on clients
might not get paud
what is the distress cost on customer
might not get the products they’ve ordered
what are the distress costs to the investors
might not get back 100% of the money they lent
what is the distress costs to the managers
take distorted business decisions
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
what does the optimal level of debt for a firm depend on (trade off theory)
volatility of cashflows
a firm with more stable cash flows might want to choose more or less debt
more
what do the costs of actual bankruptcy include
lawyers
fire sale of assets
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
what is the pecking order theory
firms prefer to issue debt rather than equity if internal finance is sufficient
what is the order in which firms prefer to finance
internal funding -> debt -> equity
how do public companies close the gap of asymmetric information
publishing their accounts
what is assymetric information
when the firm knows more about their decisions than their investors
keeping matters internal to the firm
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
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
what type of financing takes the least negative signals
reinvesting retained earnings
which companies might the pecking order theory might not be relevant for
those with no internal funds
those with no ability to borrow
what type of firms is the pecking order theory most relevant for
older and mature firms
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
what is financial slack
ready access to cash or debt financing
benefits of more financial slack
management has access to cash more quickly
what type of firms is financial slack more important in
value adding firms
where does long run value rest more in
capital investments
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
cashflows of liability payments should match WHAT as closely as possible
cashflows of assets
when debt is raised, the maturity should match what
asset maturity
don’t want to be raising new debt to pay off old debt
what should be considered when raising debt
debt and asset maturity
fixed vs floating rate
currency of debt instruments
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
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
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
formula for the effective tax advantage of debt ie after personal taxes
1 - (((1-corp tax)(1-income tax))/(1-tax on interest income)
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
what is financial distress
when a firm has difficulty meeting its debt obligations
what is a default
when a firm fails to make the required interest or principal payments on its debt
two forms of bankruptcy protection in US
Chapter 7 - Liquidation
Chapter 11 - Reorganisation
what is chapter 7 liquidation
firms assets are liquidised
proceeds used to pay the firms creditors
after the firm ceases to exist
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
direct costs of bannkrupcy
fire sale of assets
legal costs/hiring outside experts
indirect costs of bankrupcy
loss of customers
loss of suppliers
loss of employees, difficulty hiring new employees
loss of receivables
costs to creditors
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)
what effects the probability of financial distress
amount of a firm’s liabilities relative to assets
volatility of cash flows and asset values
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
is the present value of distress costs higher for higher or lower beta firms
higher beta firms
what is a debt covenant
agreements between a company and its lenders that the company will operated within certain rules set by the ledners
what is the effect of concentration and ownership
using leverage preserves ownership
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
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)
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
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
