Overall Flashcards
(42 cards)
static tradeoff theory
The static tradeoff theory is one of the main capital
structure theories and poses that firms have a target
debt ratio based on the advantages and disadvantages of debt. One advantage of debt is the tax treatment of interest, whereas a disadvantage is the cost of financial distress. The static tradeoff theory could also include agency costs.
market timing theory
The market timing theory poses that firms issue financial securities when managers believe that these are overvalued, and repurchase securities when managers believe these are undervalued. A firm’s capital structure could be the result of managers’ historical attempts to time the market
What is the main risk that merger arbitrageurs face?
The main risk for merger arbitrageurs is that the merger does not finalize and that the stock price of the target firm drops
What signal can convertible call delay provide on the future value of the firm? Please explain
The firm expects high stock prices in the future. More specifically, managers believe that the conversion option will be in-the-money at maturity (i.e. that the firm’s stock price will exceed the conversion price), so there is no need to call
How can stock options play a role in providing retention incentives?
Through their vesting periods: The rewards can only be collected after a specified period, and one cannot sell the options
How could a market crash affect the role that stock
options play in providing retention incentives?
After a market crash, granted options are not very useful for retention. When the stock price falls far below the exercise price, the options become almost valueless and the executive would be better off by going to a new firm and receiving new options there, as the new options would have the current stock price as the
exercise price.
Assume that an executive only gets compensated in the form of a bonus based on annual earnings. Which incentives are created when the executive hits the bonus cap long before the end of the year?
The created incentives are to postpone earnings and to withhold effort, as this year’s bonus is already at its maximum.
It is often argued that the presence of large investors might improve corporate governance by reducing the agency problem. Please discuss the relevant agency problem and the link between the agency problem and large investors.
▪ The relevant agency problem here is that managers might have different incentives than shareholders. Although shareholders own
the firm, the managers make most of the decisions. Examples of relevant agency problems include overinvestment, expropriation, and staying too long at the firm.
▪ Having large shareholders could increase the monitoring of the managers. Large shareholders have the incentives to monitor (“to
be informed”) and the power to make demands
According to the static tradeoff theory, should profitable firms have higher or lower leverage, all else equal?
The static tradeoff theory predicts that profitable firms have higher leverage, all else equal
▪ 1) Profitable firms pay higher taxes and thus could use the tax shields provided by debt financing
▪ 2) Profitable firms have a lower probability of financial distress and can thus take on more debt financing
▪ 3) Profitable firms are more likely to have high free cash flows and are thus more likely to face overinvestment by managers: the interest payments related to debt financing reduce free cash flows and discipline the manager
Assume we are in the Myers-Majluf (1984) world. Explain carefully how the manager’s decision to invest (i.e. issue equity) depends on the slack, assets-in-place, and investment opportunities of the
firm.
Myers and Majluf (1984) show that old shareholders
only favor an equity issue if the increment to firm value (which is based on the equity issue and the investment opportunity) obtained by them exceeds the share of existing assets and slack going to new shareholders
▪ Issue if (E / (P + E)) * (s + a) ≤ (P / (P + E)) * (E + b)
Why is slack valuable for current shareholders in the Myers-Majluf world?
Slack is valuable because no external financing is
required with ample slack available, and information
asymmetry becomes irrelevant. With ample slack, all
positive investment opportunities will be taken on
What does the empirical evidence on the average stock price performance in the years following an equity issue show?
Underperformance of equity issuers compared to firms that do not issue equity
What are the main benefits that Apple will derive from this bond issue? Do you think the huge cash balance for a company like Apple is problematic? Discuss briefly.
The debt issue brings substantial tax advantages.
▪ The additional benefit is that interest payments could reduce overinvestment problems, which could be a problem of having large cash reserves.
▪ Note that for Apple, which might have many investment opportunities, it could be valuable to have cash reserves (for example to finance acquisitions).
In a world with no information asymmetry, no costs of a failed call, and no dividends, what would optimal call policy be from the shareholders’ perspective?
▪ Under some assumptions, it is in the best interest of the convertible bondholder to never convert before maturity
▪ The assumptions include no information asymmetry and no dividends
▪ By waiting you leave your options open
▪ In that case, the firm should call as soon as the
conversion value first exceeds the call price
▪ This is because the firm should represent the
shareholders
▪ Calling takes away the option of the convertible
bondholders to wait
The firm should call as soon as the conversion value
first exceeds the call price
Discuss four main weaknesses of the design and use of typical executive stock options.
▪ Valuation: Options cost more to the firm than they are worth for the executive
▪ Dividends: Stock options create incentives to not pay dividends
▪ Market crashes and retention: When markets crash and options become far out-of-the-money, there is no retention incentive
▪ Relative performance: The option is not relative to the performance of other firms: when the overall market goes up, the value of the option is likely to go up (and vice versa), beyond the control of the manager
Discuss whether it is optimal for a U.S. firm to have a
large board, based on empirical evidence.
Empirical studies typically find a negative relation
between board size and firm value.
▪ Large boards could have more free-riding problems
▪ Large boards could have more coordination problems (slower decision-making)
▪ A large board means paying more directors
How can a controlling family use a pyramidal control
structure to benefit itself at the expense of other
shareholders?
Pyramid structures
▪ A way for an investor to control a corporation without owning high percentages of equity
▪ The investor first creates a company in which he has a controlling interest
Tunneling
▪ A conflict of interest that arises when a shareholder who
has a controlling interest in multiple firms moves profits
(and hence dividends) away from companies in which he
or she has few cash flow rights towards firms in which he
or she has more cash flow rights (“up the pyramid”)
Briefly explain merger arbitrage when the acquirer pays in stock, and explain why merger arbitrage is typically a profitable strategy.
▪ In a stock offer: Arbitrageurs buy shares of the target, while shorting stock of the acquirer
▪ The profits come from the stock price of the target not increasing enough to fully represent the bid (even after the announcement of the bid you can typically still buy a share of the target at a lower
price than what the acquirer is offering).
▪ Shorting the acquirer’s stock has the purpose of hedging against movements in the stock price of the bidder. For example, if the stock price of the bidder falls, then the bid of the acquirer is worth less than before (which is bad news if you bought shares of the target), but this decrease can be offset by the profits you make on your short position in the bidder (a short position leads to a profit when the stock price falls).
the pecking order theory
In the pecking order theory, there is no well-defined optimal debt ratio. Changes in debt ratios are driven by the need for external funds, not by any attempt to reach an optimal capital structure.The attraction of interest tax shields and the threat of financial distress are assumed second-order. Highly profitable firms with limited investment opportunities work down to low debt ratios (!)
What determines financing decisions?
1) Debt financing
2) Equity financing
Agency costs
1) Asset substitution (risk shifting)
2) Over-investment (empire building) - conflict between shareholder and management
Solutions. Higher interest rate payments reduce free cash flow.
Static tradeoff theory predictions:
Firms size (up) -> more debt financing Fixed assets (up) -> more debt financing Growth opportunities (up) -> LESS debt financing Profitability (up) -> more debt financing
Information asymmetry
some people (managers) know more than others (shareholders)
Debt policy factors
1) Financial flexibility
2) Credit rating
3) Earning and CF volatility
4) Insufficient internal funds
5) Level of interest rate risk
6) Interest tax savings
