Lecture 9 - Capital Structure Decision II

Question 1

In most countries interest payments on debt are…

Answer 1

Tax deductible.

Question 2

Tax shield from debt is…

Answer 2

Valuable assets.

Question 3

Some of the increase in equity risk and return is offset by the…

Answer 3

Tax shield from interest payment.

Question 4

What are the implications of corporate taxes, according to MM theory?

Answer 4

• All firms should borrow as much as possible.

- This maximises firm value and minimises the WACC.

Question 5

In practice, however, no one would expect the gains to apply at extreme debt ratios. Why?

Answer 5

• Other factors, such as personal taxes, personal income from personal debt and equity.
• Disadvantages of borrowing, such as financial distress, agency costs, and bankruptcy costs.

Question 6

Most investors are also taxed when they…

Answer 6

Recieve cash.

Question 7

Personal taxes reduce the…

Answer 7

Cash flows to investors and can offset some corporate tax benefits of leverage.

Question 8

Debt and equity face…

Answer 8

Differential taxation at the personal level.

Question 9

The firm should try to minimise the…

Answer 9

Present value of all taxes and maximise the after tax income.

Question 10

Financial distress occurs when…

Answer 10

Promises to creditors are broken or honoured with difficulty.

Question 11

The costs depend on…

Answer 11

The probability of distress and the magnitude of losses encountered if distress occurs.

Question 12

As you borrow more, you increase the…

Answer 12

Probability of distress and hence the expected costs.

Question 13

Bankruptcy - what are direct costs?

Answer 13

Legal and administrative expenses associated with the bankruptcy proceeding. Such as costs of lawyers, consultants and accountants etc.

Question 14

Bankruptcy - what are indirect costs?

Answer 14

Difficulties of running a company while it is going through bankruptcy.
Costs arise because people perceive you to be in financial trouble.
It is hard to measure.

Question 15

What are agency costs?

Answer 15

• Arise because of conflict of interest between shareholders and debtholders.
• Stockholders are tempted to pursue selfish strategies.
• May lead to distorted business decisions before bankruptcy.

Question 16

Debt levels are chosen to…

Answer 16

Balance interest tax shields against the costs of financial distress.

Question 17

What is the optimal/target debt level?

Answer 17

The marginal benefit of debt equals the marginal cost.

Question 18

What is the drawback of the trade off theory?

Answer 18

Difficult to express with precise and rigorous formula. Does not tell us how to mathematically calculate the optimal debt level.

Question 19

What are the predictions of trade off theory?

Answer 19

• Target debt ratios will vary from firm to firm.
• Profitable firms with safe, tangible assets ought to have high target debt ratios.
• Unprofitable firms with risky, intangible assets ought to rely primarily on equity financing.

Question 20

Is the trade off theory consistent with the practice?

Answer 20

Regarding assets, the utilities and hotels industry, in practice they use high debt ratios. Firms with risky, intangible assets, rely primarily on equity financing.
In practice, profitable firms use low debt ratios. For example, Microsoft has high operating income, high profitability, uses internal financing and does not borrow much. The trade off theory cannot explain the impact of profitability on capital structure.

Question 21

Taxes and bankruptcy costs can be viewed as…

Answer 21

Just another claim on the cash flows of the firm.

Question 22

The value of the firm is paid out to who?

Answer 22

• Shareholders,
• Bondholders
• Bankruptcy claims
• Taxes (government)

Question 23

The essence of the MM intuition is that…

Answer 23

The total firm value depends on the cash flow of the firm, depends on real assets of the firm.
Capital structure just slices the pie.

Question 24

If you can decrease tax claims…

Answer 24

You can decrease bankruptcy claims. That way you can increase total claims by bondholders and shareholders. The total size of the pie does not change. It is not affected by capital structure. If capital structure can decrease the slices by tax and bankruptcy claims, the total firm value to bondholders and shareholders will be increased.

Question 25

What is the pecking order theory?

Answer 25

• Intuition behind the theory is that there can be asymmetric information.
• Managers know more about the firm’s prospects, risks and values than do outside investors.
• Investors are unable to assess the true value of a new issues of securities by the firm.

Question 26

If a company announces it issues new stock…

Answer 26

• Investors believe managers are selling when shares are overpriced.
• So, the stock price will fall as this sends signal to the market.
• If the market price is higher than intrinsic value (true value), then managers are highly likely to sell shares.
• If the market price is lower than intrinsic value (true value), then managers will have incentives to repurchase shares.

Question 27

If managers do not want the stock price to fall…

Answer 27

They will not issue securities, particularly, stocks. They prefer internal financing (1), such as retained earnings or available cash in the firm, since it does not send a negative signal.
If internal financing is not sufficient and external financing is required, firms prefer debt (2). This is the second order of financing. Debt is less risky, and is a less worrisome signal to investors. Debt provides fixed payments to debtholders.
If debt capacity is not enough, equity (3) is issued as a last resort. Equity issues will reduce the stock price, the current market price. However, firms will only issue equity if the routes of internal financing and debt have been exhausted.

Question 28

Summarise what the pecking order theory does.

Answer 28

Tells the order of financing, internal financing then external - within that, debt then equity.

Question 29

Firms prefer to issue debt rather than equity…

Answer 29

If internal financing is insufficient. It does not consider tax shield or costs of financial distress.

Question 30

The pecking order theory can explain why most profitable firms generally borrow…

Answer 30

Less. They reinvest retained earnings. They have internal financing and so do not need to rely on external financing.

• No clear target debt ratio.
• Works best for mature firms such as Microsoft or Coca Cola, not fast growing high tech firms such as Google and Apple. The latter firms are growing rapidly and so when they issue stocks, stock issuance is not considered a negative signal by investors. Fast growing high tech firms can use equity financing because when they issue stocks, this action is not considered by investors as a negative signal. This signals the potential of the firm to grow rapidly in the future.
• Highlights the importance of financial slack (i.e. ready access to cash or debt financing).
• Firms should retain large amount of cash for new projects and for profitable investments.

Question 31

Financial slack can lead to the free cash flow problem. What is this?

Answer 31

If a firm doesn’t have good corporate governance mechanisms, this can lead to selfish managers. This problem is also linked to high agency costs.
The free cash flow problem is where managers with ample cash flow are tempted to over invest and to operate inefficiently. Debt can be used to motivate managers because managers have to pay interest payments and principals to debtholders. This motivates them to work harder as these need to be paid.

Question 32

How do firms establish capital structure?

Answer 32

• Most corporations have low debt asset ratios.
• A number of firms use no debt. These are called zero leverage firms.
• There are differences in capital structure across industries.
• Most corporations employ target debt ratios. This does not mean debt ratios are fixed every year. These can fluctuate around the target debt ratios.
• Capital structures of individual firms can vary significantly over time. This depends on their growing maturity phases and firm cycle. A firm growing rapidly at an early stage will use equity financing, but if it goes into mature stage, then it will use internal financing mainly.

Question 33

What are the four important factors that can lead to different capital structures?

Answer 33

• Flexibility.
• Taxes.
• Types of assets (intangible and tangible).
• Uncertainty of operating income.