Debt Policy and Optimal Capital Structure

Question 1

What is ranking for people’s preferences on long-term finance?

Answer 1

1. Retained earnings
   2/3. Debt
2. Equity
   5/6. Preferred

Question 2

What does book debt ratio and market debt ratio average between?

Answer 2

30-45%
20-35%

Question 3

is market debt ratio or book debt ratio more volatile?

Answer 3

Market debt ratio is more volatile

Question 4

What are the benefits of debt? (2)

Answer 4

Tax Benefits
Adds discipline to management

Question 5

What are the costs of debt? (3)

Answer 5

Bankruptcy Costs
Agency Costs
Loss of Future Flexibility

Question 6

What is meant by tax benefits?

Answer 6

When you borrow money, you are allowed to deduct interest expenses from your income to arrive at taxable income. This reduces your taxes

Question 7

When using equity financing, is it tax deductible?

Answer 7

You are not allowed to deduct payments to equity (such as dividends) to arrive at taxable income

Question 8

Other things being equal, the higher the marginal tax rate of a business…

Answer 8

…the more debt it will have in its capital structure.

Question 9

Look at Tax and WACC slides

Question 10

How does debt add discipline to management?

Answer 10

If you are managers of a firm with no debt, and you generate high income and cash flows each year, you tend to become complacent.
Forcing such a firm to borrow money can be an antidote to the complacency. The managers now have to ensure that the investments they make will earn at least enough return to cover the interest expenses

Question 11

Why would managers of publicly traded firms not want to take on debt?

Answer 11

Managers of publicly traded firms with substantial cash flows and little debt are much more protected from the consequences of their mistakes

Question 12

What are two pieces of supporting evidence of why debt adds discipline to management?

Answer 12

First, poorly managed, poorly run firms, where managers are not significant stockholders, are more likely to be targeted for leveraged buyouts.
Second, there is evidence of improvements in operating efficiency at firms that increase their debt ratio substantially.

Question 13

What is a leveraged buyout?

Answer 13

A type of acquisition where a company is purchased using a combination of equity and debt.

Question 14

Assume that you buy into this argument that debt adds discipline to management. Which of the following types of companies will most benefit from debt adding this discipline?
a) Conservatively financed (very little debt), privately owned businesses
b) Conservatively financed, publicly traded companies, with stocks held by millions of investors, none of whom hold a large percent of the stock.
c) Conservatively financed, publicly traded companies, with an activist and primarily institutional holding

Answer 14

b because individual shareholders owning only a small ‘piece’ of the company is not powerful enough to monitor and influence the behaviours of the managers

Question 15

Expected bankruptcy cost is a function of two variables, what are these variables?

Answer 15

The probability of bankruptcy, which will depend upon how uncertain you are about future cash flows

The cost of going bankrupt

Question 16

What are the costs of bankruptcy split into and explain each?

Answer 16

Direct costs: Legal and other Deadweight Costs
Indirect costs: Costs arising because people perceive you to be in financial trouble

Question 17

Firms with more volatile earnings and cash flows will have higher probabilities…

Answer 17

…of bankruptcy at any given level of debt and for any given level of earnings

Question 18

Other things being equal, the greater the indirect bankruptcy cost…

Answer 18

…the less debt the firm can afford to use for any given level of debt

Question 19

Where do indirect costs come from?

Answer 19

Comes from the perception that you are in financial trouble, which in turn affects sales and the capacity to raise credit

Question 20

What type of firms are indirect bankruptcy costs higher?

Answer 20

Firms that sell durable products with long lives that require replacement parts and service.
Firms that provide goods or services for which quality is an important attribute but is difficult to determine in advance.
Firms producing products whose value to customers depends on the services and complementary products supplied by independent companies

Question 21

How do you calculate the overall market value?

Answer 21

Overall market value = Value if all equity financed + PV tax shield - PV costs of financial distress

Question 22

What does marginal benefit of debt equal?

Answer 22

Marginal cost

Question 23

What does The Trade-off between Tax Benefit and Financial Distress Costs look like?

Answer 23

Look on slides

Question 24

What are agency costs?

Answer 24

When you lend money to a business, you are allowing the stockholders to use that money in the course of running that business. Shareholders interests are different from your interests

Question 25

Why are shareholders interests different from your interest? (2)

Answer 25

You (as lender) are interested in getting your money back
Stockholders are interested in maximizing their wealth

Question 26

What can the clash of interests between the agents and managers lead managers to do?

Answer 26

Investing in riskier projects than you would want them to
Paying shareholders large dividends when you would rather have them keep the cash in the business

Question 27

Other things being equal, the greater the agency problems associated with lending to a firm,..

Answer 27

…the less debt the firm can afford to use.

Question 28

Paying a large dividend may make stockholders happier but they make lenders less well off, what do lenders do to factor in this tendency?

Answer 28

charging a higher interest rate up front for the loan
Putting restrictive covenants on the loan

Question 29

What is meant by the loss of future financing flexibility?

Answer 29

When a firm borrows up to its capacity, it loses the flexibility of financing future projects with debt

Question 30

Other things remaining equal, the more uncertain a firm is about its future financing requirements and projects…

Answer 30

…the less debt the firm will use for financing current projects.

Question 31

What do financial officers of large US companies rank highest in the factors that they consider important in the financing decision?

Answer 31

Maintain financial flexibility

Question 32

What flexibility do firms want to maintain when referring to financing decisions?

Answer 32

The flexibility that firms want to maintain is the flexibility to be able to fund that once in a lifetime investment that may come along or to protect themselves against that devastating downside risk…

Question 33

What is the Pecking Order Theory?

Answer 33

Outside investors assume managers know more about their companies’ prospects, risks, and values (asymmetric information). This info cost is reflected in security prices.

Online: The pecking order theory states that managers display the following preference of sources to fund investment opportunities: first, through the company’s retained earnings, followed by debt, and choosing equity financing as a last resort.

Question 34

What are characteristics of the pecking order theory?

Answer 34

Internal funds has no cost.

Information cost is higher for external sources of funds.

Strict financing hierarchy: : internal (cheapest)→ debt → equity (most expensive)

Sticky dividend policy

Valuable financial slack

Question 35

Who does pecking order work best for?

Answer 35

Works best for large, mature firms that have access to public bond markets. These firms rarely issue equity.

Question 36

What is financial slack?

Answer 36

The untapped debt potential of a company

Question 37

What are the 4 steps to the optimal capital structure decision using the cost of capital model?

Answer 37

1. Estimate the Cost of Equity at different levels of debt
2. Estimate the Cost of Debt at different levels of debt
3. Estimate the Cost of Capital (WACC) at different levels of debt
4. Choose the capital structure that minimises WACC, and evaluate the effect on Firm Value and Stock Price

Question 38

How do you analyse the estimate of the cost of equity at different levels of debt as debt increases?

Answer 38

Higher debt → Equity will become riskier → Beta will increase → Cost of Equity will increase

Question 39

How does pecking order theory arise?

Answer 39

Due to asymmetric information

Question 40

How do you analyse the estimate of the cost of debt at different levels of debt as debt increases?

Answer 40

Higher debt → Default risk will go up and bond ratings will go down as debt goes up → Cost of Debt will increase

Question 41

What happens to the cost of capital as the debt ratio goes up and why?

Answer 41

Becomes lower at least initially as you take on more debt ( because you are substituting in cheaper debt for more expensive equity), then starts to increase.

Question 42

How can you determine the correct debt ratio in terms of cost of capital?

Answer 42

find the debt ratio where the cost of capital is minimised.

Question 43

What is an unlevered beta ?

Answer 43

the beta of an all-equity company

Question 44

Look at slides to see calculations of beta

Question 45

What do people use interest cover ratio to derive?

Answer 45

The synthetic rating

Question 46

What are the benefits of reduced leverage?

Answer 46

Lower cost of equity because equity risk (levered beta) is reduced

Lower default risk of the bonds