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Basic Corporate Finance > Lecture 5,6 & 7: Capital Structure (Chapter 16) > Flashcards

Lecture 5,6 & 7: Capital Structure (Chapter 16) Flashcards

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1
Q

What is capital structure?

A

It is a collection of securities a firm issues to raise capital from investors.

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2
Q

What are the most common financing?

A

1) through equity alone

2) through the combination of debt and equity.

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3
Q

What do firms consider before making a decision on which sources of financing should they obtain?

A
  • whether will they receive a fair price in the market
  • is there any tax consequences
  • does it entail any transaction costs
  • any change in future investment opportunities
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4
Q

Debt-to-value ratio

A

It is the fraction of the firm’s total value that corresponds to the debt. Formula = D/(E+D)

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5
Q

Is it true that the capital structure varies across industries?

A

Yes.

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6
Q

What are the characteristics of a perfect capital market?

A
  • securities are fairly priced (investorss & firms can trade the same set of securities at competitive market place = PV of future cash flows)
  • no tax consequences or transaction costs or issuance costs related to financing decisions
  • investment cash flows are independent of financing choices (firm’s financing decision do not change the cash flows generated by its investment)
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7
Q

What is the difference between unlevered equity and levered equity?

A

Unlevered equity: the firm is financed solely by equity only

Levered equity: the firm is financed by a combination of debt and equity

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8
Q

How do we calculate the value of a security?

A

It is the present value of its future cash flows

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9
Q

Is it true that leverage will increase the risk of firm’s equity and raise its equity cost of capital?

A

Yes

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10
Q

What does MM perfect capital markets tell us?

A
  • the total value of a firm should not depend on its capital structure
  • in an unlevered firm, cash flows to equity = free cash flows from firm’s assets
  • in a levered firm, the same cash flows are divided equally between debt and equity holders
  • the total to all investors = the free cash flows generated by the firm’s assets
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11
Q

What is the formula to find the value of levered firm?

A

VL = Debt + Equity

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12
Q

What is the formula to find the value of unlevered firm?

A

Value of cash flow / (1+cost of capital)

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13
Q

What does MM Proposition I tells us?

A

In a perfect capital market, the total value of firm = the market value of the free cash flows generated by its assets and isn’t affected by its choice of capital structure. (whether its solely equity or a mixture of debt and equity)
Formula VL = E+D = VU
Total value of the firm remains unchanged w/ or w/o leverage.

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14
Q

Is it true that leverage equity holders have a higher risks?

A

Yes, thus they’re compensated w/ higher expected return. Leverage increases the risk of equity even when there is no risk of default.

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15
Q

What are the effects of leverage on risk and return?

A
  • leverage increases the risk of equity of a firm
  • to compensate for higher risk, leverage equity holders receive a higher expected return
  • the double of risk justifies a doubling of risk premium (levered equity will be compensated w/ higher risk premium since it’s more risky)

NOTE: Leverage increases the risk of equity even when there’s no risk that the firm will default.

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16
Q

What is homemade leverage?

A

Investors use leverage in their own portfolio to adjust the firm’s leverage. It is a perfect substitute for the use of leverage by the firm in a perfect capital market.
Adding leverage will reduce the out of pocket costs of security but increases the risk of portfolio.

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17
Q

What is the formula for weighted average cost of capital (pretax WACC) in a perfect capital market?

A

Ru = D/D+E(rd) + E/D+E(re)

Note: the cost of debt (rd) is not adjusted for taxes because we’re assuming a “perfect capital market” and thus ignoring taxes.

Expected return of portfolio should equal the expected return of unlevered firm. Pretax WACC = unlevered cost of capital

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18
Q

What does MM Proposition II (the cost of capital of levered equity) tells us?

A

The cost of capital of levered equity = the cost of unlevered equity + a premium proportional to the D:E ratio.
Re = Ru + D/E(ru-rd)

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19
Q

What are the advantages of using debt as a source of financing?

A
  • it allows for tax benefit which in turn reduces the tax payable by company
  • it makes managers work more efficiently to avoide any default on obligations
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20
Q

Market imperfections can create a role for the capital structure.

A

In terms of corporate taxes,

  • corp. can deduct interest expenses to reduce the amount of tax payable
  • increases the amount available to pay investors (interest are paid to debt holders instead of paying it as “tax” to the gov)
  • increases the value of corp.
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21
Q

The gain to investors (debt holders) from the tax deductibility of interest payments are known as interest tax shield.

A

Interest tax shield = corp. tax rate x interest payments

The additional amount a firm can pay to its investors by saving on taxes it’d have paid if it did not have leverage (debt in capital structure).
Interest payments are subsidized by the gov, therefore the corp. enjoys the tax benefits.

22
Q

What is the value of interest tax shield?

A

When a firm uses debt, interest tax shield provides a corp. tax benefit each year. To determine the benefit, the PV of the stream of future interest tax shields is computed.
CF(L) = CF(u) + Interest tax shield (Dt)
- by increasing the CF paid to debt holders through interest payments, a firm reduces the amount paid in taxes
- The increase in total CF paid to investors is the interest tax shield (total of interest x marginal tax rate every year)

23
Q

What does MM Proposition I with taxes tell us?

A

The total value of levered firm exceeds the value of the firm w/o leverage due to the PV of tax savings from debt.
VL = VU + PV(interest tax shield aka Dt)

24
Q

Interest tax shield with permanent debt. Why is permanent debt necessary?

A

It is to ensure that there’s always tax benefit, thus increasing the return to equity and increasing the value of firm.

25
Q

What are the factors causing the level of future interest payment to vary?

A
  • changes in the amount of debt outstanding
  • changes in the interest rate on debt
  • changes in the firm’s marginal tax rate
  • the risk that the firm may default & fail to make an interest payment
26
Q

If firm’s marginal tax rate is constant, then, here is the formula:

A

PV (interest tax shield) = PV(tax x future interest payments) = Tax x D

27
Q

What is the formula to calculate the weighted average cost of capital w/ taxes?

A

R(wacc) = re(E/E+D) + rd(1-t)(D/D+E)
The reduction in WACC increases w/ the amount of debt financing. The higher the debt, the lower the WACC because Ke > Kd.
The higher the firm’s leverage, the more the firm exploits the tax advantage of debt, and the lower its WACC.

28
Q

What happens when the firm has high leverage?

A

The more the firm exploits the tax advantage of debt, and the lower its WACC.

29
Q

What is the bottom line?

A

Interest tax shield can be included when assessing firm value by:

a) disclosing FCF using the pretax WACC & adding the PV of future interest tax shield or
b) discounting FCF using the WACC w/ taxes

30
Q

What are the drawbacks of debt financing?

A

The costs of bankruptcy and financial distress when firms aren’t able to meet their obligations when they come due. (default in payments/ obligations).
The higher the debt, the higher the chance that the firm will default on its debt obligation.

31
Q

What does it mean when a firm is going through financial distress?

A

It means that a firm has trouble meeting its debt obligations.

32
Q

What are direct costs of bankruptcy?

A
  • it is an orderly process for settling a firm’s debts which is complex, time consuming as well as costly. It requires outside professionnals. Creditors might also incur costs during the process as they often wait several years to receive the payments.
    The more complicated the business operations, the higher the direct costs for firms.
33
Q

What are the indirect costs of financial distress?

A
  • it is difficult to measure accurately and often much larger than direct costs of bankruptcy
  • occurs when firm back out on both implicit and explicit commitments & contracts
    Some of the eg of indirect costs are:
    1) loss of customers: customers are unwilling to purchase products whose value depends on future support / service from the firm
    2) loss of suppliers: suppliers are unwilling to provide a firm w/ inventory if they fear they’ll not be paid
    3) cost to employees: firms that offer employees w/ explicit long-term employment contracts but during bankruptcy, these employees can still be laid off
    4) fire sales of assets: companies in distress may be forced to sell assets quickly to pay off its creditors
34
Q

What does the Tradeoff Theory tells us?

A

The total value of levered firm (VL) = the value of the firm w/o leverage (VU) + PV of tax shield - PV of financial distress costs.
It weights the benefit of debt and the result from shielding cash flows from taxes against the cost of financial distress associated w/ leverage.

35
Q

What are the key qualitative factors in determining the PV of financial distress costs?

A
  1. The probability of financial distress
    - likelihood that a firm will default
    - increases w/ the amount of liabilities
    - increases w/ the volatility of a firm’s cash flow & asset values
  2. Magnitude of direct & indirect costs related to financial distress that the firm will incur
    - the relative importance of the sources of these costs & likely to vary by industry
36
Q

What is the optimal leverage?

A
  • When debt increses, tax benefits of debt increases until interest expense exceeds EBIT
  • probability of default & hence the PV of financial distress costs also increases
  • the optimal level of debt occurs when value of the levered firm is maximised
  • the optimal level of debt will be lower for firms w/ higher cost of financial distress
37
Q

When there is high cost of financial distress, what is the most optimal thing to do?

A

It is more optimal for the firm to choose lower leverage.

38
Q

What are the 2 important facts about leverage that the Tradeoff Theory managed to resolve?

A
  • the presence of financial distress costs can explain why firms choose debt levels that are too low to fully exploit the interest tax shield
  • differences in magnitude of financial distress costs & volatility of cash flows can explain the differences in the use of leverage across industries
39
Q

What are agency costs?

A

It refers to the costs that arise when there are conflicts of interest between stakeholders. There is no separation of ownership & control. Managers make decisions that benefit themselves at investor’s expense, reduce their effor, spend excessively on perks and engage in empire building.

40
Q

What is Managerial Entrenchment?

A

It arise due to the seperation of ownership & control, which managers make decisions that benefit themselves at the expense of the investors.
If such decisions have -ve NPV, then they are considered a form of agency cost.

41
Q

Why do debts provide incentive for managers to run the firm efficiently?

A
  • ownership may remain more concentrated, improving monitoring of management
  • since interest & principal payments are required, debt reduces the funds available at the management’s discretion to use wastefully
42
Q

What are the instances where equity-debt holder conflicts may arise?

A

It exists if investment decisions have diff consequences for the value of equity & the value of debt, especially when the risk of financial distress is high and managers can take actions that benefit shareholders but harm creditors & lower the value of the firm.

43
Q

In cases where equity-debt holder conflicts arise, agency costs for a co. in distress will likely default in due to?

A
  1. excessive risk-taking
    - risk project could save the firm even if the expected outcome is so poor that it’d normally be rejected
  2. under-investment problem
    - shareholders could decline new projects
    - management could distribute as much as possible to shareholders before the bondholders take over bcs shareholders will always have the priority
  • the higher the debt, the more the value of firm (due to interest tax shield & the improvement in managerial incentives)
  • if leverage is too high, firm value is reduced by PV of financial distress costs and agency costs
  • therefore, the optimal level of debt balances these benefits & cost of leverage
44
Q

What is asymmetric information?

A

It refers to management’s info about the firm & its future cash flows is likely to be superior to that of outside investors. This may motivate managers to alter the firm’s capital structure.

45
Q

What is leverage as a credible signal?

A

Managers use leverage to convince investors that the firm will grow, even if they cannot provide verifiable details. Leverage used to signal good info is known as signalling theory of debt.

46
Q

When is the appropriate market timing?

A

Managers sell new shares when they believe the stock is overvalued, and rely on debt & retained earning if they believe the stock is undervalued.

47
Q

When will managers normally issue equity?

A

When the stock is overpriced. Investors will discount the price they are willing to pay for the stock. Managers do not want to sell equity at a discount so they may seek other forms of financing.

48
Q

What is the Pecking Order hypothesis?

A

Managers have preference to fund investment using retained earnings, followed by debt and will only choose to issue equity as a last resort.

49
Q

How can we evaluate the financing alternatives?

A

By comparing what the firrm would have to pay to get the financing vs. what its managers believe it should pay if the market had the same info they do.

50
Q

How should managers consider the most appropriate capital structure for the firm?

A
  • use interest tax shield if firm has consistent taxable income
  • balance tax benefits of debt against the cost of financial distress
  • consider short-term debt for external financing when agency costs are significant
  • increase leverage to signal confidence in firm’s ability to meet its obligations
  • rely firstly on retained earnings, then debt and finally equity
  • don’t change the firm’s capital structure unles it departs significantly from the optimal level

Basic Corporate Finance (15 decks)

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