the concept of risk in corporate finance Flashcards
which are the two main financing alternatives for a company?
- share capital
- debt capital
the main difference being the contractual nature of rights and obligations
what are the advantages and disadvantages of debt?
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
what are the 2 shareholder liability regimes?
- limited liability: shareholders are only responsible for the contributed capital, and not personally liable for the debt towards debtholders in the case of bankruptcy
- unlimited liability: shareholders are responsible with their personal wealth for the company’s obligations
What is enterprise value?
The value generated by operating activities, distributed among shareholders and debtholders
Bankruptcy costs
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.
what happens to the payoff to debt and shareholders in case of limited liability and bankruptcy costs
payoff to shareholders remains identical, payoff to debt holders (in the event of bankruptcy) is diminished
what is cost of capital?
an opportunity cost, the return offered by the market on assets characterized by the same degree of risk
what is risk?
uncertainty
What is the difference between financial risk and default risk?
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
why is the distribution of enterprise values relevant?
because it is the primary determinant of debt default risk (EV<D)and the resulting cost of debt capital
