Topic 11- Financing Analysis: Capital Structure Flashcards
Is debt or equity paid first?
debt
Debt is the promise of
fixed payments in the future
What happens if debt payments aren’t made?
shareholders can lose control of the firm
for debt interest is
tax deductible
low or high priority for debt in financial trouble?
high
low or high priority for equity in financial trouble?
low
debt does or doesn’t have management control
doesn’t
2 examples of debt
bank debt, bonds
equity is when equity holders
get (or reinvest) the leftover CFs after debt payments are made
equity is what type of claim?
residual
dividends are or aren’t tax deductible
aren’t
life of equity vs debt
equity inf, debt fixed
equity does or doesn’t have management control
does
2 examples of equity
owner’s equity (in a limited partnership) or common shares (corporate)
3 advantages of debt
- tax benefit
- disciple
- incentives to managers to increase CFs of the firm
Tax benefit is when
int expenses on debt are tax deductible
CFs for equity aren’t
tax deductible
increase in tax rate decreases or increases tax benefit
increase
for disciple borrowing forces
managers to be careful and not invest stupidly
an increase in separation between managers and stockholders creates an increase in
tax benefit
3 disadvantages of debt
- insolvency costs
- agency costs
- loss of flexibility
insolvency costs are due to
an increase in debt meaning an increase in the likelihood of NOT being able to make debt payments
bankruptcy costs formula
E(b)= prob(going bankrupt) x cost (going bankrupt)
with more volatile earnings comes an increase in
the porb of going bankrupt
firms with high/low bankruptcy costs should borrow more/less for any given level of earnings
low, more
agency costs arise from
actions by managers and shareholders that benefit themselves not the firm
a greater potential for conflict comes from an
increase cost borne by borrowers (increased IR)
what types of firms should borrow more?
firms with lenders monitoring how the $$ is used
Why is loss of flexibility a disadvantage for debt?
borrowing capacity of debt means less flexibility to finance other projects with debt
increase in debt intake==== (4 pts)
increase int payments,increase tax shield, increase tax benefit, increase bankruptcy costs
value of a levered firm=
value of un levered firm + PV (tax shield)
does industry depend on debt?
yes
industry dependant on debt pharmaceuticals examples
- a riskier firm such as pharmaceuticals as they are constantly developing new tech to sell should have less debt
industry dependant on debt utilities examples
- a low-risk firm such as utilities with strong assets (dam, power plant…) should take on more debt
debt amplifies/ ….
leverages risk
debt creates fixed
commitments
there is more ??? for levered firms CFs
volatility
with debt in a recession net income
increases more
if you have mortgage you are decreasing/leveraging risk
leveraging
when buying a house you have 3 components
- house worth
-deposit/eq - bank principal
the relationship between NPV and debt
increase in debt, decreases NPV
enterprise value is the p…
present value of all FCFs
if FCFs are held constant and _____ the value of firm ____
cost of capital minimized, maximized
__ debt,__ wacc/coc, __ firm value,
increase, decrease, increase
do you want a high or low wacc?
low
capital restructuring is all about
changing proportions on the RHS of BS without changing firm assets
increase leverage by issuing
bonds and repurchasing shares
decrease leverage by issuing
issuing new shares and retiring outstanding debt (get shares to pay off the debt)
the goal of capital restructuring is to
determine the leverage that maximizes firm value (or decrease wacc)
int payments are/aren’t tax deductible
are
dividend payments are/aren’t tax deductible
aren’t
distributing cash to security holders through interest payments does what to the firm value?
increases
