Limits to use of debt H16 Flashcards
Debt can be used as a tax shield
True
bancrupcy is costly
yep, it has steep legual fees, lowers trust in the company and creates conflicts of interest within the firm
Why might there be moral hazard when a firm is heading for bankrupcy
Because equity is residual taking a cautius aproach might not give anything to shareholders if everything goes well so the managers might be incentivized to take more risks for the off chance that the shareholders will get anything.
Name some selfish investment strategies that may occur when a firm heads for bankrupcy
A firms may avoid raising extra equity if they belive the banks will just take it all even if they have investment opportunities with a positive npv. Thay may also pay large dividends to milk the firm for all it is worth before it goes under and managers are incentiiced to take on more risk.
What firms are likely to be highly leveraged
Firms that have a verry low risk of bankrupcy like nationalized banks
What are protective covenants with creditors
Contracts to limit interest rates in exchange for f.ex limiting the size of dividends in the case of negative covenants or make periodical financial statements in the case of positive covenants.
What is the optimal level of indebtedness of a firm
The part where the marginal tax benefits are equal to the marginal likely cost of bankrupcy. Although as the marginal cost of bankrupcy is uncertain and cannot yet be calculated this theory does not predict the actions of real firms
What are market and non market claims for a companies assets
Market claims are credit and equity liabilities while non makarket claims are f.ex the governments claim to taxes and lawyser claims to legual fees. When talking about the value of a firm only market claims are counted
Increased leverage is a signal for increased value in a firm
True, even if the managers know it is a signal and try to trick the investors more valueable firms can take out more debt.
Managers work harder if they are the owners of a substantial part of their firm
True, at least generally according to adam smith, therefor leveraged buyouts tend to te profitable
What is the free cashflow hypothesis
The emperically proven pattern that firms with more cash on hand tend to make worse investments and acquisitions.
What is the pecking order theory
The idea that firms will issue equity when overvalued and debt when undervalued as that is most in their interest but that investors know this and will not buy equity for anything but a discount when equity is issued leading to debt financing being all around superior.
Why does the pecking order theory encurage internal financing
To avoid investor speculation regarding financing
The pecking order theory espouses to issue the safest securities first
Yes, issue debt untill you have reached capacity
