Module 11 Flashcards
what is capital structure?
the mix of debt and equity a company uses to finance its operations
characteristics of debt?
- includes all borrowed funds
- long term or short term
- secured against assets or unsecured
what is financial leverage?
measured by the proportion of total financing represented by debt in the firm’s capital structure. concerned with the relationship between a firm’s EBIT and EPS.
what is the relationship between debt proportion and financial leverage?
higher proportion in cap structure = higher degree of leverage
why is studying cap structure important?
- the use of debt comes w both costs and benefits
- amt of financial leverage in cap structure affects firm value
what is capital restructuring?
changing the amt of financial leverage a firm has without changing productive assets
how can a firm inc financial leverage?
- issuing debt
- repurchasing outstanding shares
- increasing div payout
how can a firm dec financial leverage?
- issuing new shares
- retiring outstanding debt
- reducing div payout
what are factors that affect firm value using the FCFTF method?
- amt and timing of CF
- the WACC as a discount rate
what is the primary goal of financial management?
to maximize shareholder wealth
how can we use cap structure to maximize SH wealth?
by minimizing WACC – smaller discount rate = higher PV of FCFTF
role of WACC in capital structure?
WACC = discount rate
what is business risk?
risk that relates to firm operations
what is leverage?
the effects of fixed costs on the return of ordinary shareholders = must be paid regardless
how can mgmt limit the negative impact of leverage?
- by adopting strategies that rely less on fixed costs
- outsource products instead of manufacturing
- adopt an optimal capital structure
impact of leverage on return and risk?
- controls risk and maximizes SH returns
- can maximizes both
what is operating leverage?
- a component of business risk
- concerned with the relationship between a firm’s sales revenue and its EBIT
what happens when operating costs are largely fixed?
small revenue changes will lead to large EBIT changes
how does financial risk arise?
from use of debt in cap structure (interest and capital risk is included)
what is effect of debt on EPS
will be geared up during an economic upswing and downwards during downswing
similarities between operating and financial leverage?
- both refer to the effects of fixed costs on risk and return for SH
- both magnify R&R when high
differences between operating and financial leverage?
- OL arises from large fixed op costs and FL arises from large fixed int costs
- OL = rev and EBIT, FL = EBIT and EPS
what is optimal capital structure?
the d:e ratio that results in the lowest WACC and maximizes firm value. minimizes the cost of financing firm activities.
what does M&M proposition 1 state?
the capital structure decisions a firm makes will not effect firm value nor the risk of CF produced by firm assets (WACC also doesn’t change w changes)
what does the real investment policy of the firm include?
the criteria it uses to decide which real assets to invest in
what is firm value?
the total value of the firm’s assets = value of equity + value of debt financing used
what does M&M proposition 1 mean for the investor?
they can make changes in their own inv accounts that will replicate cash flows for any cap structure that mgmt may choose or inv may want. bc they can do this on their own, they are not willing to pay more for shares in a firm that will do it for them.
why does cap structure not affect real assets?
because cap structure decision do not affect the level, timing and risk of CF produced by those assets. it does however change the risk of RR on equity with changes in capital structure
what does M&M proposition 2 state?
that the cost (RRR) of a firm’s OS is directly related to the debt-equity ratio
criteria for M&M 1?
- no taxes
- no transaction costs
- the real investment policy of the firm is not affected by cap structure decisions
M&M case 1 assumptions?
firm value is not determined by cap structure, nor is WACC. no optimal structure. ke inc with debt.
M&M case 2 assumptions?
(has tax / but no agency / insolvency costs)
- firm value will increase by the PV of the int tax shield (reduces tax when debt increases)
- the value of a levered firm will be higher than unlevered by the PV of annual int tax shield
- WACC decr as de ratio inc
- optimum cap structure is 100%
M&M case 3 assumptions?
(the real world)
- debt inc as WACC inc (tax reduces debt cost = inc firm value)
- at optimal cap structure, value will start to decr and wacc will inc as more debt is added
consequences of too much debt?
- increased cost of insolvency
- inc kd – at some point the additional value of the tax shield is offset by insolvency cost
what is the trade-off theory?
balances the tax adv of debt against insolvency costs when choosing optimal capital structure. this theory recognizes that there is a OCS which max firm value and min WACC.
TOT and target debt ratios?
- recognizes that target debt ratios may vary from firm to firm.
- firms w safe tangible assets and plenty of inc will have high ratios
- unprofitable firms with risky assets should not rely on debt
failures of TOT?
fails to explain why some of the most profitable comps thrive on little debt. it predicts the opposite. fails to explain large diffs between debt ratios of firms in the same industry.
what is the pecking order theory?
financing theory that assumes there is no OCS and that financing will follow a hierarchy:
- RE
- issue of debt / loan
- issue of PS
- OS
why are retained earnings first for POT?
- no issue costs – cheapest source of finance
- no control issues
why is debt 2nd for POT?
will result in debt covenants and can limit mgmt decisions
why is OS fourth for POT?
- can impact control of the firm
- high issue costs
what does POT explain?
- explains why most profitable firms generally borrow less (do not need external money, they have RE)
- explains why most unprofitable firms use more debt – not enough int funds
factors mgmt might consider when choosing debt policy
financial flexibility
credit rating
insufficient internal funds
int tax shield
dividend cover
EPS / DPS
what are dividend policies?
the strategy a company follows in paying dividends
share price today
D1 / (k-g) = P0
(if d1 inc then p0 inc)
(if g dec, share price falls)
(dividend / gordon growth model)
what does the Bird in Hand theory state?
there is a direct relationship betw dividend policy and firm value and therefore should be actively managed (inc = inc). a current dividend paid in cash is more valuable/less risky than uncertain future cap gains/growth
how BIHT works?
div paid = ke dec = earnings are discounted at a lower rate = higher firm value
what does the M&M theory of div irrelevance state?
div pmts reduce the growth potential of the company – should only do so when they have no further profitable investments
- only holds with no tax / brokerage costs and infinitely divisible shares
what does the M&M argument state?
- assumes that, given certain assumptions, div policy has no effect on company value – it is a passive variable
- rather firm value is determined by its future earning power and inv riskiness
investors vs a firm’s dividend policy
- don’t care, can create their own
- if they think divs are high, they can use the excess cash to buy more dividends
- if too low, sell some shares
why divs don’t affect share price according to M&M?
if a div is decl and paid, the firm will have to issue new shares to that value. more shares will be in issue for the same assets – dilution.
what does M&M says about investors RRR?
it is unaffected by dividend policy:
- firm value is determined by future earnings and asset risks
- they only affect it because of their informational content
what is the residual approach?
- suggests that dividends are a passive variable: what is left over after financing and inv decisions have been made
- a company should accept all projects exceeding its RRR/WACC. remaining funds = dividends.
how can a company adopt the residual approach?
it must identify:
1) identify its set of inv opportunities
2) its RRR
3) its target debt ratio
factors that affect the dividend decision?
- legal constraints
- contractual constraints
- internal constraints
- future growth prospects
- owner consideration
- clientele effect
- info content of divs
how legal constraints affect the dividend decision?
legal requirements from company’s act that restrict div decl/pmts to protect long term debt providers:
- cannot be paid out of capital reserves
- may only div if they meet liquidity requirements
how contractual constraints affect the dividend decision?
can be restricted by loan covenants in loan agreements to protect debt providers against potential future losses due to insolvency
how internal constraints affect the dividend decision?
may have a low level of liquid assets / low conversion to cash
how future growth prospects affect the dividend decision?
firm may have future expansion plans and will need all available funding to finance these plans – therefore cannot issue dividends / must be able to raise funds externally (share issue)
how owner considerations affect the dividend decision?
- if the shareholders are in a high tax bracket, they may pay out lower % of its earnings to allow the owners to
delay the payment of taxes until they sell their
shares - the firm should not inv in things that the SH could do elsewhere for a better return
- dilution of ownership – more earnings pd out = more shares to issue to make up for this lost $$
what is the clientele effect?
SH are attracted to comps that satisfy their investment needs regarding the balance between cash income and capital growth
how the clientele effect effects the dividend decision?
- SH who require constant inc will inv in a company with a higher dividend yield
- don’t require constant inc = higher growth firm
- investors cannot easily swap out shares bc of transaction costs, flotation costs
how the info content of divs affects the dividend decision?
- the firm may declare big div to signal its confidence in its future earnings potential
- can also indicate to mgmt that the comp can grow and sustain the fin performance and inc div payout into the future
div payout policies?
divs should vary over time like profits and inv does. it could inconvenience/turn invs away if the div is not consistent.
stable div amount?
fixed Rand amount of Dividend regardless of Earnings for current year
stable payout ratio?
fixed portion (%) of earnings which remains the same
