the concept of risk in corporate finance

Question 1

which are the two main financing alternatives for a company?

Answer 1

1. share capital
2. debt capital

the main difference being the contractual nature of rights and obligations

Question 2

what are the advantages and disadvantages of debt?

Answer 2

Advantages:
- tax benefit
- greater “discipline”

Disadvantages:
- bankruptcy costs
- agency costs (conflicts of interest between debtholders and shareholders)
- too much debt leads to a loss in future financial flexibility

Question 3

what are the 2 shareholder liability regimes?

Answer 3

1. limited liability: shareholders are only responsible for the contributed capital, and not personally liable for the debt towards debtholders in the case of bankruptcy
2. unlimited liability: shareholders are responsible with their personal wealth for the company’s obligations

Question 4

What is enterprise value?

Answer 4

The value generated by operating activities, distributed among shareholders and debtholders

Question 5

Bankruptcy costs

Answer 5

in the hypothesis that EV is lower than the value of debt, the perspective goes from a “going concern” to bankruptcy and liquidation of assets.

Overall payoff = EV - bankruptcy costs

legal fees, accounting fees, etc.

Question 6

what happens to the payoff to debt and shareholders in case of limited liability and bankruptcy costs

Answer 6

payoff to shareholders remains identical, payoff to debt holders (in the event of bankruptcy) is diminished

Question 7

what is cost of capital?

Answer 7

an opportunity cost, the return offered by the market on assets characterized by the same degree of risk

Question 8

what is risk?

Answer 8

uncertainty

Question 9

What is the difference between financial risk and default risk?

Answer 9

in case of an increase in financial risk, the expected returns remain the same but standard deviation increases

in case of an increase in default risk (only negative possible outcomes), an increase in risk always implies a reduction in the expected value of returns

Question 10

why is the distribution of enterprise values relevant?

Answer 10

because it is the primary determinant of debt default risk (EV<D)and the resulting cost of debt capital