Introduction

Question 1

Main capital structure theories?

Answer 1

1) Static trade-off theory
2) Pecking order theory

Question 2

Static trade of theory

Answer 2

Form a leverage target that optimally balances various costs (financial distress costs, stockholder-debtholder agency conflicts) and benefits (tax savings, mitigated manager-shareholder agency costs) of debt.

Question 3

Pecking order theory

Answer 3

Follow a financing hierarchy designed to minimize adverse selection costs of security issuance

Question 4

Debt ratio principle

Answer 4

• Firm with steady CF and liquid assets (collateral) - higher debt ratios
• Risky firms, with low current CF and intangible assets or intangible growth options - low debt ratios

Question 5

Pecking order in financing

Answer 5

1) Internal financing
2) Debt financing
3) Equity financing

Question 6

FRICTO

Answer 6

Flexibility
Risk
Income
Control
Timing
Other

Question 7

Flexibility (FRICTO)

Answer 7

• Increasing debt restricts firm for seeking more debt in the future due to high debt levels
• Might violate loan covenants
• Firms with flexibility always have access to financial markets and have the options to chose the financing type of its liking
  Debt imposes payment of interest (and principal) and might have covenants and collateral involved

> > > Debt removes flexibility of firms (+ Equity)

Question 8

Risk (FRICTO)

Answer 8

• Meet debt service (interest and principal)
• Financial distress and bankruptcy risk increase with debt
• Volatility of CF and earnings
• More debt increases the risk of both creditors and shareholders

> > > Debt increases the financial risk of a company (+ Equity)

Question 9

Income (FRICTO)

Answer 9

• Net income is affected by the tax shield and the interest payments
• Effect on EPS and ROE
• Compare its cost of additional borrowing with its capacity to generate income (pre-tax ROA) –> if pre-tax ROA generated with debt > borrowing rate –> borrow more since ROE increases

> > > By paying interest to the creditors you avoid paying to the tax authority - tax shield (+ Debt)

Question 10

Control (FRICTO)

Answer 10

• Impact on the control over the company held by each shareholder
• Issuing additional common shares will dilute this control

(+ Debt)

Question 11

Timing (FRICTO)

Answer 11

• Friendliness of capital markets (debt and equity markets)
• Interest rate level and direction
• Current stock price for stock issuance
• Time when funds will be needed

Question 12

Other (FRICTO)

Answer 12

• Attitude of management and sharehodlers towards debt
• Length the financing is needed
• Disciplining role of debt
• Effect on company’s bond rating

Question 13

Time Value of Money

Answer 13

The value of future CF is lower than the value of present CF

Question 14

Impact factors on interest rates (of debt)

Answer 14

1) Expected inflation rate
2) Debtor’s default risk
3) Return on alternative investment opportunities

Question 15

Simple interest

Answer 15

Interest payments will be received at the end of each period (and can be used freely)
Interest earned only on the original capital invested.

Question 16

Compound interest

Answer 16

Interests will be received at the end of the operation.
Interest earned on the interest and the original capital invested.

Question 17

Net Present Value (NPV)

Answer 17

NPV > 0: project increases value
NPV = 0: project compensates for its level of risk
NPV < 0: project decreases value

Question 18

Alternative techniques for project evaluation

Answer 18

• Payback method
• Internal rate of return (IRR)

Question 19

Payback method

Answer 19

Payback period is the number of years needed to recover the initial investment.

Objective: accept the projects with payback period < K years

Question 20

Payback method
+ / -

Answer 20

+
Time value of money is not taken into account
CF that take place after K years are neglected (penalising long-term porjects)

-
Difficult to estimated CF (uncertainty)
Short-term CF generation is crucial to start new projects when companies have cash restrictions
Attractive to managers that are assessed based on short-term results

Question 21

FCFF

Answer 21

CF from operations available for distribution after taxes, depreciation expenses, working capital, and investments are accounted for and paid.

> > > measure of a company’s profitability after all expenses and reinvestments

> > > Amount available to both debt and equity holders

Question 22

Working Capital

Answer 22

WC = Current Assets - Current Liabilities