Lecture 4a: Capital Structure Flashcards
1.) Observed capital structure practices 2.) Impact of Tax, Financial Distress, Agency, Information Asymmetry and Asset Type
What is capital structure
Mix of sources of funds for the company (Debt & Equity)
What is a property of capital structure managers and investors commonly observe?
A significant tax advantage in using debt since interest payments are tax deductible (no tax)
What is the problem with the common observation “Use lots of debt = Save money”
Using too much debt is risky and should be avoided
Do firms commonly have a target D/E ratio
Yes
Do firms in the same industry have the same D/E ratio
Yes they tend to as they have their projects often have the same risk.
What is Conservation of Value
Regardless of cash flow, value of an asset (firm) remains the same.
What happens if the total values of two firms are different (same operation cash flow; different capital structures)
Investors will recognize a mispricing and can make an arbitrage by buying undervalued and selling overvalued.
What is the formula for Business Risk
K0
What is the formula for Financial Risk
Kd
Who faces business and financial risk
Shareholders ONLY. Debtholders DO NOT face these risks (they face default risk instead)
What happens to the firm when the debt increases
Total risk = Constant; Debt payments are concentrated upon smaller fraction of shareholder - increasing Ke
What are two costs associated with debt
- ) Explicit, direct cost - Interest payments
2. ) Implicit, indirect costs - Increased expected rate of return by shareholders
What happens if the debt is not risk free
Some of the financial risk is borne by debtholders instead of equity holders.
Note: It does not change the cost of capital - just the division of expected returns between debt and shareholders
What is the basics of the classical tax system
Equity: Taxed twice (Company + Personal)
Debt: Taxed once (Personal)
What sources of fund does the classical tax system favour (Theoretically). Explain.
Debt. This is because debt is only taxed once
What sources of fund does the classical tax system favour (Practically). Explain.
Neither. This is because the savings from tax may be passed onto lenders in the form of higher interest rate on debt to compensate lenders for the additional PERSONAL tax payable.
What sources of fund does the imputation tax system favour.
Either neutral or biased towards equity - depending on investors marginal tax rate.
For investors with high tax rate:
It is unknown or better.
For investors with equal <= company tax rate:
Neutral
What is the mathematical intuition behind what the tax systems favour (Classical)
Classical: Franking does not apply
Under the formula, K0 = ke (E/V) + kd (D/V) (1 - te).
Remember te = tc (1-y):
If y is 0 (classical); te = tc (30%)»_space;> 0.7 kd (D/V).
From a company perspective, debt is favoured as they have to pay a lower cost of debt.
What is the mathematical intuition behind what the tax systems favour (Imputation)
Imputation: Franking apply
Under the formula, K0 = ke (E/V) + kd (D/V) (1 - te).
Remember te = tc (1-y):
If y is 1 (imputation fully franked); te = 0»_space;> 1 kd (D/V).
From a company perspective, it is neutral or leaning towards equity depending on franking.
When are taxes especially important in the financing decision
Especially when companies are in different tax systems. Can reap tax advantages of debt
Can equity returned in the form of capital gains be taxed
May/may not be taxed
What are the 5 factors influence a company’s capital structure decision
- ) Taxation
- ) Financial Distress
- ) Agency Costs
- ) Information Asymmetry
- ) Asset Type
FACTOR 2: What is financial distress in the capital structure decision of firms
When it has difficulties meeting its commitment to LENDER (not necessary liquidation, liquidation in serious situations)
What are the 2 broad costs of financial distress
- ) Direct Costs/Bankruptcy costs (where formal control is transferred to lenders)
- ) Indirect costs of financial distress
What are the direct costs of bankruptcy
Fees paid to lawyers, accountants, liquidators [TANGIBLE]
What are indirect costs of bankruptcy
Lost sales, reduced operating efficiency [INTANGIBLE]
How does debt influence financial distress
Borrowing/Debt > Increase probability of bankruptcy costs (Even if it is small) > Increase PV (Expected Bankruptcy Cost) > Decrease value of the company
How do we calculate bankruptcy costs
PV (Expected Bankruptcy Costs) = P (Bankruptcy) x Cost incurred if it occurs
What kind of risks are bankruptcy related to
Business (e.g. retail vs marketing) and Financial Risk (from borrowing)
Who bears the costs when a company is actually liquidated and what are these liquidation costs called. Explain
Realized liquidation costs. Lenders because shareholders seldom receive a return
Who bears the costs when a company is in the process of liquidation and what are these liquidation costs called. Explain.
Expected liquidation costs. Because lenders, knowing that the company will be liquidated > Demand higher interest rate > lowering the firm’s payout to shareholders.
What are indirect costs of financial distress and what does it result
Indirect: Loss of sales, etc… Companies will have lower levels of debt to reduce the possibility of these costs being incurred
FACTOR 3: What is agency costs in the capital structure decision of firms
Conflict of interests between parties
What are the 4 conflicts between lenders and shareholders. What is the assumption?
- ) Claim Dilution
- ) Dividend Payout
- ) Asset Substitution
- ) Underinvestment
Managers are on the same team as shareholders (i.e. Managers act in shareholders’ interest)
What is the conflict between shareholders and managers
Managers invests in free cash flows in unprofitable projects (e.g. takeovers).
Borrowing more (Debt) > Debt holders will monitor more > Force company to not invest in wasteful projects as they have to pay back interests.
Increase debt
Explain the conflict “Claim Dilution”
New Debt Rank > Old Debt Rank
Older debt holders less secure claim
Wealth transfer from old debtholders to shareholders
(Think: Put Option and Exercise Price)
Explain the conflict “Dividend Payout”
+ dividend payout
- company’s assets
+ D/E Ratio (Financial risk)
Wealth transfers from debtholders to shareholders
(Think: Diagram of Firm Value)
Explain the conflict “Asset Substitution”
High D/E Ratio > Incentive to take risk using debt.
(Successful = Shareholders benefit
Unsuccessful = Debtholders bear)
Accept High Risk Negative NPV Projects
Wealth transfer from debtholders to shareholders
(Think: Call option)
Explain the conflict “Under-investment”
Risky debt
Shareholders won’t want to contribute additional capital
Reject - Risk + NPV projects
Wealth transfer from debtholders to shareholders
(Think: Call option)
What happens when lenders realize that managers are making decisions in the shareholders’ best interest
- ) Lenders will impose a higher interest rate than required to compensate. Borne by shareholders
- ) Lenders will require covenants. Borne by company value and shareholders
FACTOR 4: What is informational asymmetry in a company’s capital structuring decision
Pecking order of financing sources:
Internal Finance > Debt > Hybrid > Equity
Explain why there is a pecking order of financing sources. 2 Explanations
- ) Transaction Costs
- Internal lower - ) Information Costs (Signalling)
- Managers know more information
- New shares = Believe shares are overpriced = Share market receive signal
FACTOR 5: What is asset type in a company’s capital structuring decision
- ) General-purpose asset > Company-specific asset
2. ) Tangible asset > Intangible asset
Explain how asset type affects a company’s capital structuring decision
- Value of general/tangible assets easier to realise if the company defaults
- Lower debt risk
Companies with high proportion of general/tangible asset has more debt capacity and tend to have higher D/E ratio
Which one promotes debt, which one does not
- ) Taxation
- ) Financial Distress
- ) Agency Costs
- ) Information Asymmetry
- ) Asset Type
1.) Taxation
a - Classical: Yes
b - Imputation: Neutral/Equity
2.) Financial Distress
Lower Debt
3.) Agency Costs
a - SH v Lenders: Lower Debt
b - SH v Managers: Higher Debt
4.) Information Asymmetry
Higher Debt
5.) Asset Type
General/Tangible: Higher Debt
Specific/Intangible: Lower Debt
According to a survey, is tax advantage a big deal in a firm’s financing decision
NO. Financial flexibility and risks are more important
What is the significance of “Conservation of Value” in relation to the capital structure
- Market value (V) is not affected by its capital structure.
- Annual Net Operating Cash Flow (NCF) is not affected by its capital structure
- Cost of Capital (K0) = NCF/V. Hence, not affected by its capital structure
What is Conservation of Risk
Since value is conserved, total risk is conserved by concentrated the increased risk on a smaller number of shareholders (Ke increases)
Under the imputation tax system, what would high/low personal tax investors favor for equity
High Tax: Capital gain (avoid personal and get franking on company)
Low Tax: Dividends (think retirees)
Is a company in financial distress in liquidation
Not necessarily. Just has difficulty
In 4 conflicts between lenders and shareholders, where does the wealth transfer?
From lenders to shareholders. All 4 of them.
Who does debt covenants protect
All parties
What are the disadvantages of debt covenants
- ) Monitoring will be required
- ) Opportunity costs in cases where covenants are too restrictive and prevent managers from taking on value-maximizing decisions.
