Debt Policy and Optimal Capital Structure Flashcards
What is ranking for people’s preferences on long-term finance?
- Retained earnings
2/3. Debt - Equity
5/6. Preferred
What does book debt ratio and market debt ratio average between?
30-45%
20-35%
is market debt ratio or book debt ratio more volatile?
Market debt ratio is more volatile
What are the benefits of debt? (2)
Tax Benefits
Adds discipline to management
What are the costs of debt? (3)
Bankruptcy Costs
Agency Costs
Loss of Future Flexibility
What is meant by tax benefits?
When you borrow money, you are allowed to deduct interest expenses from your income to arrive at taxable income. This reduces your taxes
When using equity financing, is it tax deductible?
You are not allowed to deduct payments to equity (such as dividends) to arrive at taxable income
Other things being equal, the higher the marginal tax rate of a business…
…the more debt it will have in its capital structure.
Look at Tax and WACC slides
How does debt add discipline to management?
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
Why would managers of publicly traded firms not want to take on debt?
Managers of publicly traded firms with substantial cash flows and little debt are much more protected from the consequences of their mistakes
What are two pieces of supporting evidence of why debt adds discipline to management?
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.
What is a leveraged buyout?
A type of acquisition where a company is purchased using a combination of equity and debt.
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
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
Expected bankruptcy cost is a function of two variables, what are these variables?
The probability of bankruptcy, which will depend upon how uncertain you are about future cash flows
The cost of going bankrupt
What are the costs of bankruptcy split into and explain each?
Direct costs: Legal and other Deadweight Costs
Indirect costs: Costs arising because people perceive you to be in financial trouble
Firms with more volatile earnings and cash flows will have higher probabilities…
…of bankruptcy at any given level of debt and for any given level of earnings
Other things being equal, the greater the indirect bankruptcy cost…
…the less debt the firm can afford to use for any given level of debt
Where do indirect costs come from?
Comes from the perception that you are in financial trouble, which in turn affects sales and the capacity to raise credit
What type of firms are indirect bankruptcy costs higher?
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
How do you calculate the overall market value?
Overall market value = Value if all equity financed + PV tax shield - PV costs of financial distress
What does marginal benefit of debt equal?
Marginal cost
What does The Trade-off between Tax Benefit and Financial Distress Costs look like?
Look on slides
What are agency costs?
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
Why are shareholders interests different from your interest? (2)
You (as lender) are interested in getting your money back
Stockholders are interested in maximizing their wealth
What can the clash of interests between the agents and managers lead managers to do?
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
Other things being equal, the greater the agency problems associated with lending to a firm,..
…the less debt the firm can afford to use.
Paying a large dividend may make stockholders happier but they make lenders less well off, what do lenders do to factor in this tendency?
charging a higher interest rate up front for the loan
Putting restrictive covenants on the loan
What is meant by the loss of future financing flexibility?
When a firm borrows up to its capacity, it loses the flexibility of financing future projects with debt
Other things remaining equal, the more uncertain a firm is about its future financing requirements and projects…
…the less debt the firm will use for financing current projects.
What do financial officers of large US companies rank highest in the factors that they consider important in the financing decision?
Maintain financial flexibility
What flexibility do firms want to maintain when referring to financing decisions?
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…
What is the Pecking Order Theory?
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.
What are characteristics of the pecking order theory?
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
Who does pecking order work best for?
Works best for large, mature firms that have access to public bond markets. These firms rarely issue equity.
What is financial slack?
The untapped debt potential of a company
What are the 4 steps to the optimal capital structure decision using the cost of capital model?
- Estimate the Cost of Equity at different levels of debt
- Estimate the Cost of Debt at different levels of debt
- Estimate the Cost of Capital (WACC) at different levels of debt
- Choose the capital structure that minimises WACC, and evaluate the effect on Firm Value and Stock Price
How do you analyse the estimate of the cost of equity at different levels of debt as debt increases?
Higher debt → Equity will become riskier → Beta will increase → Cost of Equity will increase
How does pecking order theory arise?
Due to asymmetric information
How do you analyse the estimate of the cost of debt at different levels of debt as debt increases?
Higher debt → Default risk will go up and bond ratings will go down as debt goes up → Cost of Debt will increase
What happens to the cost of capital as the debt ratio goes up and why?
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.
How can you determine the correct debt ratio in terms of cost of capital?
find the debt ratio where the cost of capital is minimised.
What is an unlevered beta ?
the beta of an all-equity company
Look at slides to see calculations of beta
What do people use interest cover ratio to derive?
The synthetic rating
What are the benefits of reduced leverage?
Lower cost of equity because equity risk (levered beta) is reduced
Lower default risk of the bonds
