Lent Term - Lecture 6

Question 1

What is co-funding?

Answer 1

Using both internal and external financing

Question 2

What happens to the bad firm if the good firm self-finances?

Answer 2

The bad firm can no longer pool to use external financing as it will be identified. Therefore it becomes indifferent to internal or external financing (unless there is a cost to external financing e.g. a small fee)

Question 3

Why is debt preferred to equity in the pecking order?

Answer 3

Debt is less sensitive to asymmetric information than equity. A debt contract minimises the discount incurred by the good type.

Question 4

Why does the pecking order imply no real optimal capital structure?

Answer 4

Because in the pecking order changes in debt rations are driven by the need for external finance

Question 5

Pecking order theory vs Trade-off theory

Answer 5

The pecking order theory implies that leverage may be inversely related to profitability while the trade-off theory implies that debt improves firm value

Question 6

Why is external financing costly?

Answer 6

Because good firms receive finance at a discount

Question 7

What can share issues and repurchases tell us about a firm?

Answer 7

Issues - Shares are overvalued

Repurchases - Shares are undervalued and the firm expects future profit to be high

Question 8

What does the enriched version of the pecking order take into account?

Answer 8

Cost of financial distress - The firm will issue equity when costs of financial distress become significant