Theory of Capital structure

Question 1

What are the basic properties of debt and equity?

Answer 1

• Claim on firm’s returns
o Debt = prior claim
o Equity = residual claim
→ Debt = less risky and cost of debt always less than cost of equity

• Control rights
o SH have control as long as debt covenants satisfied

Question 2

What did MM show ?

Answer 2

• Capital structure does not matter for firm’s V

* Unlevered firm and levered firm exactly same mkt value = solely determined by return distribution

Question 3

What are the MM two propositions?

Answer 3

• Mkt value of any firm = independent of capital structure

* WACC independent of firm capital structure

Question 4

What are MM assumptions ?

Answer 4

• Perfect capital mrkts
• No taxes
• No costs of insolvency or financial distress
• No agency costs

Question 5

Why do firms not totally exploit the tax shield effect?

Answer 5

Financial distress and bankruptcy are costly. A firm borrows up to point D/E* where marginal increase in value due to tax shield offset by increase in PV of cost of financial distress

Question 6

What is the trade-off theory?

Answer 6

Firms trading off tax shield’s marginal benefit vs cost of financial distress implies:
• Stable CFs
• Tangible assets
tend to borrow more than firms with volatile business models and mainly intangible assets

Question 7

What are the empirical problems of trade-off theory?

Answer 7

• At least some firms with superior credit ratings and stable CFs operate at very conservative debt levels
• Profitability seems to be negatively correlated with leverage

Question 8

What is the pecking order theory?

Answer 8

1. Internal finance over external
2. If insufficient, issue safest security, debt
3. Last resort = equity

Question 9

By what is the firm’s decision driven whether to issue equity or debt?

Answer 9

• From existing SH: issue equity = attractive only if shares currently overvalued
• From new SH: issue of equity = bad signal about firm’s value

→ Issue new equity only at discounted price
→Issuing equity negative impact on share price

Question 10

Why can the firm mitigate the negative signal about its value if it finances projects by issuing debt instead of equity?

Answer 10

• Prior claim vs residual for equity
• Less risky and less affected by errors in valuation
• Negligible effect on stock price

Question 11

What are the 4 ways of manifestation of the conflict of interest between debt and equity?

Answer 11

• Risk shifting
o SH benefit from increase in risk at expense of debtholder

• Exploiting existing debtholders through additional borrowing

• Debt overhang
o New investors refuse to invest in new project since most payoff would go to debtholder

• Playing for time
o Conceal a problem to avoid immediate bankruptcy or reorganization

Question 12

What do self-interested managers seek in the conflicts between managers and shareholders ?

Answer 12

• Higher than mkt salaries
• Perquisites
• Job security
• Direct capture of assets and CFs

Question 13

What do self-interested managers favor in the conflicts between managers and shareholders ?

Answer 13

• Entrenching investments
• Overinvestment
• Empire building

Question 14

What do banks enjoy compared to creditors of non-financial firms ?

Answer 14

Government protection via:
• Deposit insurance
• Anticipated government aid during systemic crisis

Question 15

What is the potential role for capital regulation?

Answer 15

• Without any restrictions, banks tend to minimize equity in order to maximize option value of governemnt0s liability insurance
• Bank’s incentive to take excessive risks increases with leverage
• Externalities in case of financial distress create discrepancy between socially optimal debt to equity ratio and the one preferred by banks

Question 16

How would the pecking order be if we consider banks ?

Answer 16

• Issue equity = very costly as BS very opaque and hard to value
• Deposit-taking = cheap because of deposit insurance and short maturities make deposits easy to value.