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2nd Year - Finance 2 > Lecture 8 - Capital Structure Decision I > Flashcards

Lecture 8 - Capital Structure Decision I Flashcards

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1
Q

Real investment policies imply funding needs. Sources of funds include…

A
  • Internal funds (cash).
  • Debt borrowing, financial leverage, gearing (bank loans vs bonds).
  • Equity (issuing common vs preferred stocks).
  • Others (convertible bonds).
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2
Q

Debt creates…

A

Financial leverage/gearing.

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3
Q

Debt increases returns to shareholders in good times and…

A

Reduces them in bad times. The variability of returns to shareholders is greater if a firm increases debt ratio. This increases the financial risk to shareholders.

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4
Q

Financial managers should balance different risk factors to ensure…

A

That the overall risk faced by stockholders is acceptable.

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5
Q

What is business risk?

A

Associated with competing in the marketplace.

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6
Q

What is operating risk?

A

Caused by the proportion of costs that are fixed - operating leverage. If a firm has a high proportion of fixed costs then the firm has higher degree of operating leverage. Then the variability of operating risk will be higher.

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7
Q

What is financial risk?

A

Caused by the proportion of debt - financial leverage.

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8
Q

Market value of equity is greater than the book value of…

A

Equity.

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9
Q

Why is the market value of equity greater than book value of equity?

A

Because firms have a potential to grow in the future.

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10
Q

What is capital structure?

A

Financing mix of long term debt and equity.

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11
Q

The primary objective of capital structure management is to…

A

Maximise the total value of the firm’s outstanding debt and equity.

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12
Q

The resulting financing mix that maximises the combined value is called the…

A

Optimal capital structure.

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13
Q

Explain the pie model.

A

The value of a firm as a pie. The goal of the manager is to increase the size of the pie. The capital structure decision reflects how best to slice up the pie. If how you slice the pie affects the size of the pie, then the capital structure decision matters.

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14
Q

What are the two questions surrounding capital structure?

A
  1. Why should shareholders in the firm care about maximising the value of the entire firm?
    - Does a policy that maximises the total value of the firm also maximise the wealth of the shareholders?
  2. What is the ratio of debt to equity that maximises the shareholders’ interest?
    - Is there an actual debt to equity ratio? If so, how can this be measured?
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15
Q

Any increase or decrease in firm value caused by a shift in capital accrues…

A

To shareholders.

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16
Q

A policy that maximises the market value of the firm is also best for…

A

The firm’s shareholders.

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17
Q

Firm value maximisation is consistent with…

A

Shareholder wealth maximisation.

18
Q

What is the traditional view of capital structure?

A
  • Intuitive view.
  • Taxation is ignored.
  • Focuses on the relationship between firm value and company cost of capital (WACC).
  • The firm distributes all its earnings to shareholders.
  • Dividends are the same as earnings.
  • Payout ratio is 100%. Payout ratio is 1.
  • Retained earnings are 0.
  • Retention ratio is 0.
  • Growth rate in earnings, dividends is 0.
19
Q

To maximise the total firm value, that is to…

A

Minimise the WACC.

20
Q

What is the Modigliani and Miller 1958 Theory?

A

Assumptions of perfectly efficient markets:

  • No taxation, Tc = 0
  • No transaction costs.
  • Individual investors can borrow or lend on the same terms as firms.
  • Securities are fairly price; no information asymmetry.
  • No bankruptcy costs or agency costs.
21
Q

Capital structure does no affect…

A

Operating cash flows. Cash flows are not affected by borrowing, or the mix of debt and equity.

22
Q

What is the proposition I?

A

The choice of capital structure is irrelevant for maximising the value of the firm. The value of the firm is determined by the assets of the firm rather than the capital structure.

23
Q

What is the proposition II?

A

Says that the greater the proportion of debt in the capital structure, the greater the rate of return required by shareholders.

24
Q

What is the law of one price?

A

In a well functioning market, two investments that offer the same payoff must have the same price. If the investments that offer the same payoff do not have the same price, an arbitrage opportunity occurs and rational investors in the market will buy under priced securities and sell over priced securities. After time there will be equilibrium, the investments will have the same price.

25
Q

As long as investors can borrow or lend on the same terms as the firm, they can…

A

‘Undo’ and ‘duplicate’ the effects of corporate leverage on their own.

26
Q

The market value of any firm is independent of its…

A

Capital Structure.

27
Q

What is the law of conservation of value?

A

You can slice a cash flow into many parts; the values of the parts will always sum back to the value of the unsliced stream. It doesn’t matter how you slice the pie the total size of the pie will remain unchanged.

28
Q

The value of an asset is preserved regardless…

A

Of the nature of the claims against it.

29
Q

Firm value is determined on the left hand side of the balance sheet by…

A

Real assets - not by the proportions of debt and equity issued to buy the assets.

30
Q

Investment decisions are the most important, more important than financing decisions or payout decisions, because they determine the…

A

Firm value.

31
Q

What is restructuring?

A

Process of changing the firm’s capital structure without changing its real assets.

32
Q

The slope indicates the…

A

Responsiveness of EPS to changes in firm performance, i.e. the risk to shareholders.

33
Q

The risk to shareholders increases with…

A

Leverage.

34
Q

The expected return on equity is positively related to…

A

Leverage.

35
Q

Leverage increases the expected EPS but not the…

A

Share price. This is because the change in the expected earnings is exactly offset by a change in the discount rate, i.e. expected return on share.

36
Q

The expected return on assets, ra, is equal to the…

A

Expected operating income divided by the total market value of the firm’s securities.

37
Q

In perfect capital markets, company’s borrowing decisions do not affect either the…

A

Operating income or the total market value of its securities.

38
Q

The expected return on a portfolio equals…

A

Weighted average of the expected returns on the individual holdings.

39
Q

The expected return on assets equals…

A

Weighted average of the expected returns on debt and equity.

40
Q

The expected return on the common stock of a levered firm increases in proportion to the…

A

Debt equity ratio, expressed in market values.

41
Q

Higher the debt equity ratio, the higher the…

A

Financial risk.

2nd Year - Finance 2 (10 decks)

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