Part 1: Debt Capital

Question 1

Debt Capacity

Answer 1

The amount of debt a firm is able to borrow

Question 2

Risk of debt

Answer 2

The problem of balancing the amount and timing of cash inflows and outflows (the risk of being out of cash)

Question 3

Why does firms borrow to different extents according to Myers (1977?)

Answer 3

1. Tax advantage
2. Financial distress
3. Personal taxation
4. Imperfect capital markets
5. Incomplete capital markets
6. Credit rationing
7. Managerial incentives
8. Signalling for risk and profitability
   (Explains why firms set target debt ratios in terms of book value rather than market value)
   (Explains why firms tend to match maturities of assets and debt obligations)

Question 4

Theoretical propositions of Myers (1977)

Answer 4

• Firms with risky debt will, in some states, pass up valuable investment opportunities
• By issuing risky debt, the market value of the firms should decrease because of the suboptimal strategy

(However, if there is a tax advantage, there is a trade-off between the PV of tax shields and the cost of a suboptimal strategy)

Question 5

What does Myers (1977) mean with real options?

Answer 5

The equity of a firm is a call option on the underlying value of the firm
Growth opportunities can thus be seen as a call option on a real asset = real options

Question 6

What are the takeaways from Myers (1977)?

Answer 6

• Firms with valuable growth opportunities would never issue risky debt
  (credit rationing can occur even in perfect capital markets)
• Debt might change the actions of the firm in some circumstances
  (it might lead to situations ex-post in which management can serve shareholders’ interest only by making sub-optimal decisions. Ex-ante this reduces the value of the firm and thus the shareholders’ wealth)

Question 7

Credit rationing

Answer 7

An offer by the firm to pay a higher interest rate, given that the point they cannot borrow more has been reached, reduces the credit available

Question 8

What did Myers (1984) discuss?

Answer 8

1. Static trade-off theory (target debt-to-value ratio)
2. Old pecking order framework (internal vs external; debt vs equity)
3. Modified pecking order theory

Question 9

Static trade-off theory

Answer 9

Assumes that firms identify and set a fixed capital structure, based on the trade-off between the benefits and costs at a given debt level

A negative correlation between leverage and profitability

Cost of adjustments
Taxes and debts
Costs of financial distress

Question 10

Old pecking order theory

Answer 10

1. Firms prefer internal finance to external
2. Firms adapt target dividend ratios to investment opportunities
3. Sticky dividend policies -> internally generated cash flows first
4. In case of external finance needed, debt > hybrid > equity
5. No well defined target debt-equity mix

Question 11

Modified pecking order theory

Answer 11

1. Firms tend to AVOID finance real investments by issuing common stock or other risky securities
   (because they don’t want to pass by positive NPV projects or issue undervalued stock)
2. Firms set target dividend ratios so that normal rates of equity investments can be met by internally generated funds
3. Firms tend to partly cover investments with debt, but they try to keep it safe
   (to avoid financial distress and to maintain financial slack in the form of reserve borrowing power)
4. Target dividend ratios are sticky and investments fluctuate, thus firms tend to exhaust their ability to issue safe debt
   (then turn to risky debt or convertibles, and last to common stock)

Question 12

The efficient market hypothesis

Answer 12

• An efficient market provides accurate signals for resource allocation
• Security prices should reflect all available information
• Three forms: Weak (historical prices), Semi-strong (public information), and Strong (inside information)
• Equilibrium expected return - risk relationship
• The random walk model: independence of returns over time and identically distributed returns

Question 13

How do you test for different forms of efficient markets?

Answer 13

• Weak form tests - how well do past returns reflect future returns -> return predictability
• Semi-strong form tests - how quickly do security prices reflect public information announcements? -> event studies
• Strong form tests - do investors have private information that is not fully reflected in market prices

Question 14

Equity as a call option (Merton 1974)

Answer 14

• Equity can be seen as a call option on the assets with a strike price equal to the value of debt
• If firm value exceeds the strike price, equity holders get whatever is left once the debt is paid
• If firm value does not exceed value of debt, the firm must declare bankruptcy and the equity holders receive nothing

Question 15

Debt holders as going short on a call option (Merton 1974)

Answer 15

• If firm value exceeds the dept, the call will be exercised, and the debt holders will receive the strike price
• If firm value does not exceed the debt, the call will be worthless and firm will declare bankruptcy -> the debt holders will be entitled to the firm’s assets
• Debt can also be viewed as a portfolio of risk-less debt and a short position in a put option on the firm’s asset with a strike price equal to the required debt payment -> when the assets are worth less than the debt payment, the owner of the option will exercise and receive the difference between the debt payment and the firm’s assets

Question 16

How does equity holders differ from debt holders in terms of risky investments?

Answer 16

Because equity is like a call option, equity holders will benefit from risky investments with a hight payoff
As debt is is seen as a short put position, so debt holders will be hurt by an increased risk

This can potentially lead to an over-investment problem

Question 17

What are the three factors that has implications for optimizing captial structure according to Brennan & Schwartz (1978)?

Answer 17

1. Business risk - higher risk means the variance of earnings increases, which means optimal level of debt decreases
2. Payout policy - net investments is calculated based on stock issues minus dividends paid. Lower net investment was shown to be associated with lower optimal leverage
3. Time to maturity - short-term debt can be a good way to find a balance reducing the cost of bankruptcy, and at the same time keep the benefits of the tax shield

Question 18

What is the conflict and the common ground between Trade-off theory and pecking order?

Answer 18

Conflict regarding mean reversion of leverage

Share many predictions about dividends and debt

Question 19

What is the five-step procedure proposed by Bhararth & Shumway (2008) to implement Merton (1974)’s model

Answer 19

1. Estimate volatility of equity from historical stock returns
2. Choose forecasting horizon and a measure of face value for debt
3. Collect values of the risk-free rate and market equity value
4. Solve equity equation numerically for total value and volatility of the firm
5. Calculate distance to default and implied volatility

Question 20

Why does firms set target debt ratios in terms of book value rather than market values?

Answer 20

Book values refer to assets in place

Question 21

Why do firms tend to match maturities of assets and debt obligations?

Answer 21

Debt repayment should correspond to the decline in future value of assets in place

Question 22

What are the differences and common ground between Pecking order and Trade-off theory?

Answer 22

Trade-off theory - negative relation between leverage and profitability
Pecking order - large equity issues of small low-leverage growth firms

Both models predict the relation between target dividend payout and target leverage is negative

Pay-out ratio is positively related to profitability and negatively related to investment opportunity and volatility

Question 23

Creating a riskless portfolio (browian motion)

Answer 23

Option value is assumed to be driven by a random process (brownian motion)

Because the option and the stock will follow the same source of randomness, taking opposite positions will offset the randomness -> creating a riskless portfolio

Question 24

The main idea of Black & Scholes

Answer 24

Options should be highly correlated with the underlying asset price

We should therefore be able to cancel out randomness by balancing the option and the portfolio -> earning a riskless return of K

In the absence of arbitrage K = r

Question 25

Difference between financial an operating lease

Answer 25

Operating lease 
- Not fully amortized 
- Lessee reports payments as OPEX
(- Lessor maintains and insures asset)
(- Cancellation option)

Capital (financial) lease 
- Fully amortized 
- Lessee reports lease on balance sheet
(- No maintenance or service)
(- Lessee has right to renew lease at expiration) 
(- Cannot be cancelled)

Question 26

Valid arguments for leasing

Answer 26

Tax differences 
Reduce resale costs 
Efficiency gains from specialization 
Reduced distress costs  
Increased debt capacity 
Transferring risk 
Mitigating debt overhang 
Improved incentives

Question 27

Suspect arguments for leasing

Answer 27

Avoiding capital expenditure controls
Preserving capital
Reducing leverage through off-balance-sheet financing