Lecture 2 - Capital Structure Flashcards
Financial Instruments & Corporations
Balance Sheet
On: FIs such as debt and equity
Off: Hedging instruments such as options, futures, and swaps
- Optimal mic
- Repetition: what does the MM-Theorem tell us?
Financial Instruments & Corporations
Equity Financing
Firms obtain equity capital either internally by earning and retaining money or externally by issuing new equity securities.
3 Kinds of equity a firm can issue:
- Common stock
- Preferred stock (usually not linked to votng rights, but higher and preferred dividends - paid before)
- Warranrs (options issued by the firm)
Financial Instruments & Corporations
Debt Financing
Debt instruments usually promise to pay a coupon stream and a principal epayment to the holder of the contract
A debt contract also establishes the financial requirements and restrictions that the borrower must meet –> Loan convenants
The rights of the debt holder if the borrower violated anx of the key terms of the contract must be determined
Financial Instruments & Corporations
Convenants
= Contractual restrictions imposed on the borrowing firms. The promise in a debt agreement that certain activities will or not be carried out.
Especially with risks debt outstanding, stockholders’ actions aimed at maximizing the value of their equity claim can result in a redution in the value of both the firm and its outstanding bonds
3 types
- Asset convenants
- Dividend convenants
- Financing convenants
Convenants are written to control the conflicts between bondholders and stockholders:
- Claim dilution
- Dividend payments
- Asset substitution
- Underinvestment
Financial Instruments & Corporations
Financing Patterns
Main differences between debt and equity:
- Debt claims must be paid bedore the firm makes any payments to its shareholders
- Payments to debt holders are tax-deductible eypense to the firm
- Debt financing can cause distress costs or bankruptcs costs
Major corporations frequently raise outside capiral by accessing debt markets
Equity is an important but much less frequently used source of outside capital
Financial Instruments & Corporations
Financing Patterns: How firms can raise funds?
- Plow back profit
- Bedt sources
- Equity sources
- Selling assets
Financial Instruments & Corporations
Debt Instruments
- Fixed or floating rate debt
- Decured debt
- Senior and junior debt (priority in bankruptcy process)
- Convertibel debt
- Callable debt
- Commodity-linked debt
Optimal Capital Structure
Intro
- A firm’s mix of sources of capital is referred to as its capital structure
- But how are capital structures determined?
- What is an “optimal” capital structure?
Optimal Capital Structure
Modigliani / Miller Theorem (Part I)
Optimal Capital Structure
Modigliani / Miller Theorem (Part II)
Optimal Capital Structure
MM Theorem: Implications (Part I)
Optimal Capital Structure
MM Theorem: Implications (Part II)
Optimal Capital Structure
MM Theorem: Implications (Part III)
Optimal Capital Structure
MM Theorem: Implications (Parti IV)
Optimal Capital Structure
The Impacrt of Taxes (Part I)
In some way, with its tax-advantage, the government encourages firms to take on debt.
Optimal Capital Structure
The Impact of Taxes (Part II)
According to this analysis, all firms should be 100% debt-financed!
Optimal Capital Structure
Optimal Capital Structure
The Impact of Bankruptcy Costs (Part I)
- Firms defaults if it chooses not to repay debt
- Debt causes direct and indirect bankruptcy costs
- The Optimal Capital Structure balances the tax benefits of debt against the expected costs of bankruptcy
Optimal Capital Structure
The Impact of Bankruptcy Costs (Part II)
