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FCNE20005 - CFDM > Lecture 4a: Capital Structure > Flashcards

Lecture 4a: Capital Structure Flashcards

1.) Observed capital structure practices 2.) Impact of Tax, Financial Distress, Agency, Information Asymmetry and Asset Type

1
Q

What is capital structure

A

Mix of sources of funds for the company (Debt & Equity)

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2
Q

What is a property of capital structure managers and investors commonly observe?

A

A significant tax advantage in using debt since interest payments are tax deductible (no tax)

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3
Q

What is the problem with the common observation “Use lots of debt = Save money”

A

Using too much debt is risky and should be avoided

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4
Q

Do firms commonly have a target D/E ratio

A

Yes

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5
Q

Do firms in the same industry have the same D/E ratio

A

Yes they tend to as they have their projects often have the same risk.

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6
Q

What is Conservation of Value

A

Regardless of cash flow, value of an asset (firm) remains the same.

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7
Q

What happens if the total values of two firms are different (same operation cash flow; different capital structures)

A

Investors will recognize a mispricing and can make an arbitrage by buying undervalued and selling overvalued.

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8
Q

What is the formula for Business Risk

A

K0

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9
Q

What is the formula for Financial Risk

A

Kd

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10
Q

Who faces business and financial risk

A

Shareholders ONLY. Debtholders DO NOT face these risks (they face default risk instead)

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11
Q

What happens to the firm when the debt increases

A

Total risk = Constant; Debt payments are concentrated upon smaller fraction of shareholder - increasing Ke

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12
Q

What are two costs associated with debt

A
  1. ) Explicit, direct cost - Interest payments

2. ) Implicit, indirect costs - Increased expected rate of return by shareholders

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13
Q

What happens if the debt is not risk free

A

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

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14
Q

What is the basics of the classical tax system

A

Equity: Taxed twice (Company + Personal)
Debt: Taxed once (Personal)

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15
Q

What sources of fund does the classical tax system favour (Theoretically). Explain.

A

Debt. This is because debt is only taxed once

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16
Q

What sources of fund does the classical tax system favour (Practically). Explain.

A

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.

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17
Q

What sources of fund does the imputation tax system favour.

A

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

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18
Q

What is the mathematical intuition behind what the tax systems favour (Classical)

A

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%)&raquo_space;> 0.7 kd (D/V).

From a company perspective, debt is favoured as they have to pay a lower cost of debt.

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19
Q

What is the mathematical intuition behind what the tax systems favour (Imputation)

A

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&raquo_space;> 1 kd (D/V).

From a company perspective, it is neutral or leaning towards equity depending on franking.

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20
Q

When are taxes especially important in the financing decision

A

Especially when companies are in different tax systems. Can reap tax advantages of debt

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21
Q

Can equity returned in the form of capital gains be taxed

A

May/may not be taxed

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22
Q

What are the 5 factors influence a company’s capital structure decision

A
  1. ) Taxation
  2. ) Financial Distress
  3. ) Agency Costs
  4. ) Information Asymmetry
  5. ) Asset Type
23
Q

FACTOR 2: What is financial distress in the capital structure decision of firms

A

When it has difficulties meeting its commitment to LENDER (not necessary liquidation, liquidation in serious situations)

24
Q

What are the 2 broad costs of financial distress

A
  1. ) Direct Costs/Bankruptcy costs (where formal control is transferred to lenders)
  2. ) Indirect costs of financial distress
25
Q

What are the direct costs of bankruptcy

A

Fees paid to lawyers, accountants, liquidators [TANGIBLE]

26
Q

What are indirect costs of bankruptcy

A

Lost sales, reduced operating efficiency [INTANGIBLE]

27
Q

How does debt influence financial distress

A

Borrowing/Debt > Increase probability of bankruptcy costs (Even if it is small) > Increase PV (Expected Bankruptcy Cost) > Decrease value of the company

28
Q

How do we calculate bankruptcy costs

A

PV (Expected Bankruptcy Costs) = P (Bankruptcy) x Cost incurred if it occurs

29
Q

What kind of risks are bankruptcy related to

A

Business (e.g. retail vs marketing) and Financial Risk (from borrowing)

30
Q

Who bears the costs when a company is actually liquidated and what are these liquidation costs called. Explain

A

Realized liquidation costs. Lenders because shareholders seldom receive a return

31
Q

Who bears the costs when a company is in the process of liquidation and what are these liquidation costs called. Explain.

A

Expected liquidation costs. Because lenders, knowing that the company will be liquidated > Demand higher interest rate > lowering the firm’s payout to shareholders.

32
Q

What are indirect costs of financial distress and what does it result

A

Indirect: Loss of sales, etc… Companies will have lower levels of debt to reduce the possibility of these costs being incurred

33
Q

FACTOR 3: What is agency costs in the capital structure decision of firms

A

Conflict of interests between parties

34
Q

What are the 4 conflicts between lenders and shareholders. What is the assumption?

A
  1. ) Claim Dilution
  2. ) Dividend Payout
  3. ) Asset Substitution
  4. ) Underinvestment

Managers are on the same team as shareholders (i.e. Managers act in shareholders’ interest)

35
Q

What is the conflict between shareholders and managers

A

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

36
Q

Explain the conflict “Claim Dilution”

A

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)

37
Q

Explain the conflict “Dividend Payout”

A

+ dividend payout
- company’s assets
+ D/E Ratio (Financial risk)

Wealth transfers from debtholders to shareholders

(Think: Diagram of Firm Value)

38
Q

Explain the conflict “Asset Substitution”

A

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)

39
Q

Explain the conflict “Under-investment”

A

Risky debt
Shareholders won’t want to contribute additional capital
Reject - Risk + NPV projects
Wealth transfer from debtholders to shareholders

(Think: Call option)

40
Q

What happens when lenders realize that managers are making decisions in the shareholders’ best interest

A
  1. ) Lenders will impose a higher interest rate than required to compensate. Borne by shareholders
  2. ) Lenders will require covenants. Borne by company value and shareholders
41
Q

FACTOR 4: What is informational asymmetry in a company’s capital structuring decision

A

Pecking order of financing sources:

Internal Finance > Debt > Hybrid > Equity

42
Q

Explain why there is a pecking order of financing sources. 2 Explanations

A
  1. ) Transaction Costs
    - Internal lower
  2. ) Information Costs (Signalling)
    - Managers know more information
    - New shares = Believe shares are overpriced = Share market receive signal
43
Q

FACTOR 5: What is asset type in a company’s capital structuring decision

A
  1. ) General-purpose asset > Company-specific asset

2. ) Tangible asset > Intangible asset

44
Q

Explain how asset type affects a company’s capital structuring decision

A
  • 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

45
Q

Which one promotes debt, which one does not

  1. ) Taxation
  2. ) Financial Distress
  3. ) Agency Costs
  4. ) Information Asymmetry
  5. ) Asset Type
A

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

46
Q

According to a survey, is tax advantage a big deal in a firm’s financing decision

A

NO. Financial flexibility and risks are more important

47
Q

What is the significance of “Conservation of Value” in relation to the capital structure

A
  • 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
48
Q

What is Conservation of Risk

A

Since value is conserved, total risk is conserved by concentrated the increased risk on a smaller number of shareholders (Ke increases)

49
Q

Under the imputation tax system, what would high/low personal tax investors favor for equity

A

High Tax: Capital gain (avoid personal and get franking on company)
Low Tax: Dividends (think retirees)

50
Q

Is a company in financial distress in liquidation

A

Not necessarily. Just has difficulty

51
Q

In 4 conflicts between lenders and shareholders, where does the wealth transfer?

A

From lenders to shareholders. All 4 of them.

52
Q

Who does debt covenants protect

A

All parties

53
Q

What are the disadvantages of debt covenants

A
  1. ) Monitoring will be required
  2. ) Opportunity costs in cases where covenants are too restrictive and prevent managers from taking on value-maximizing decisions.

FCNE20005 - CFDM (15 decks)

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