Session 1: Debt Policies Flashcards
How does Modigliani & Miller feel about the value of a firm?
Modigliani & Miller believe that with perfect capital markets, the total value of a firm should not depend on how its financed.
What are the 3 Assumptions of Modigliani and Miller?
- the market is efficiently priced
- there are no taxes, transaction costs, or issuance costs associated with trading
- a firm’s financing decisions doesn’t change cash flows generated by its investments
Acquisition of Debt or Equity is cheaper and why?
The acquisition of debt is cheaper since it is less risky
Modigliani-Miller Proposition I Without Taxes
In a perfect capital market, the total value of a firm equals the market value of the total cash flows generated by its assets and is NOT affected by its choice of capital structure
Define Leverage Recapitalization
a firm uses borrowed funds to pay a large special dividend or to repurchase a significant amount of outstanding shares to reduce equity
Modigliani-Miller Proposition II Without Taxes
The cost of capital of levered equity is equal to the cost of capital of unlevered equity PLUS a premium that’s proportional to the market value debt-equity ratio
What is WACC?
The Weighted Average Cost of Capital
How is WACC without taxes calculated?
rWACC = E / E + D * rE + D / E+D * rD
What does Beta measure?
The effect of leverage on the risk of a firm’s securities
What is Net Debt?
Net Debt = Debt - Cash & Risk Free Securities
Define Dilution
An increase in the total of shares which will divide a fixed amt of earnings
What causes dilution?
Share offerings
What causes stock prices to decrease when a share offering is announced?
dilution of ownership, signaling effect, supply & demand dynamics, use of proceeds, and short-term focus
Define Interest Tax Shield
the reduction in taxes paid due to the tax deductibility of interest
How is Interest Tax Shield calculated?
Interest Tax Shield = Corporate Tax Rate * Interest Payments
How is WACC with taxes calculated?
rWACC = E / E + D * rE + D / E+D * rD * 1-tc
What is the Tradeoff Theory?
a concept that explains how companies determine their optimal capital structure by balancing costs and benefits of debt and equity financing. It suggests that firms strive to reach a balance where the marginal cost of debt equals its marginal benefit.
What are the key components of the Tradeoff Theory?
- Benefits of debt
- Costs of debt
- Optimal capital structure
Define Asymmetric Information
when two parties have different information
Define Adverse Selection
when buyers and sellers have different information, the average quality of assets in the market will be lower than the average quality overall
Define Lemons Principle
when a seller has private information about the value of a good, buyers will discount the price they’re willing to pay due to adverse selection
A firm selling new shares demonstrates what?
A negative signal that perhaps their value is poor
If managers perceive the firm’s equity is underpriced, what will they do?
they will have a preference to fund investments using retained earnings rather than equity
What is the bottom line?
the optimal capital structure depends on market imperfections
