Factors Affecting Optimal D/E Ratio Flashcards
Does the risk of bankruptcy affect the value of a company in a perfect capital market?
No.
What is the effect of the risk of bankruptcy in a perfect capital market on the required return for debt capital?
Required return on debt might increase because of higher risk.
What are the two types of bankruptcy?
- Chapter 7 : liquidation
2. Chapter 11 : reorganization
What are two alternatives to bankruptcy designed to avoid additional costs?
- Workout
2. Prepackaged bankruptcy
What is a “workout” bankruptcy?
The company works out an agreement directly with the creditors.
What is a “prepackaged bankruptcy”?
The company works out a reorganization plan with the biggest creditors, the files for a chapter 11 reorganization and pressures smaller creditor to accept it.
What are the indirect costs of bankruptcy?
- Loss of customers
- Loss of employees
- Loss of suppliers
- Loss of receivables
- Fire sale of assets
- Inefficient liquidation
- Costs to creditors
What is the highest financial distress cost for a company with high human capital?
Loss of employee
Less asset to liquidate
What is the highest financial distress cost for a company selling long-term services?
Loss of customers
Based on the trade-off theory, what is the optimal amount of leverage?
incremental value of tax shield = incremental cost of financial distress
(maximize PV(Tax Shield) - PV(FD costs))
What causes the agency costs of leverage?
Conflicts of interest between management and creditors : management benefit from an increase in the stock price so might make decisions that benefit equity at the expense of debt.
What are the agency costs of leverage?
- Asset substitution problem
2. Debt overhang / under-investment problem
What is the asset substitution problem?
Replacing safe investments with negative-NPT risky investments
What is the debt overhang?
V1 : Failing to make positive NPV investments because it would not benefit equity holders (would only benefit debt holders).
V2 : Selling assets at low prices and using proceeds to pay dividends when the company is in FD.
What is the effect of an increase in the level of leverage on the debt beta?
Debt tends to increase with leverage because debt gets more risky.
What is the leverage ratchet effect?
Once a company has debt, it has an incentive to take on more debt, not to reduce it.
Why are agency costs lower for short term debt?
Less opportunity to make suboptimal decisions before repaying the capital.
What are agency benefit of leverage?
- The control of the company is in fewer hands
- Management has a greater share in equity
- Management won’t waste money on empire building (less free cash)
- Management is more likely to be fired if the company goes in FD
- The company is more likely to compete because it is closer to bankruptcy otherwise
Give the formula for trade-off theory.
VL = Vu + PV(Tax Shield) - PV(FD costs) - PV(Agency costs) + PV(agency benefits)
What is the credibility principal?
Actions speak louder than words when words are in self-interest.
Describe adverse selection.
Sellers with private information sell the least desirable items.
What is the lemon principle?
Buyers discount price when sellers have private information.
What are the effect of equity issue on the stock price:
- at the announcement of the equity issue ?
- before the announcement ?
- Drop in stock price
2. Rise before announcement because company releases good news
What is the pecking order hypothesis for financing projects?
- Retained earnings
- Debt
- Equity
