Topic 7- Capital Structure in a Perfect Market Flashcards
What are the 2 main corporate financing patterns and what do they cover?
- Internally generated funds: retained earnings
- External sources of finance: debt, equity
What is plowback profit?
Retained earnings
What are 2 main reasons for using internal funds?
- Cost of issuing securities
- New equity announcement implications
What are the 2 main costs of issuing securities and what do they cover?
- Direct costs: due diligence, underwriting
- Indirect costs: time, effort in conforming to accounting standards
What are the implications of new equity announcements?
The announcement of a new equity issue is usually bad news for investors
What are 5 main opposite differences between debt and equity?
Debt is:
- Tax deductible
- Fixed claim
- High priority in financial trouble
- Fixed maturity
- No management control
What is convertible debt?
Debt issued by a firm which can be turned into shares at maturity
What are the 2 main features of a Mezzanine (hybrid) finance model?
- Convertible stock
- Preferred stock
What is a preferred stock?
A stock which offers no voting rights to the holder but pays dividends before a common stock
What are the 2 main types of equity issues?
- Common stock
- Preferred stock
What is capital structure?
The relative proportions of debt, equity and other securities that a firm has outstanding that are used to finance assets
Give 2 main measures of capital structure in terms of financial leverage (gearing) and their respective equations
- Debt-to-equity ratio: D/E = (D/V)/(1-D/V)
- Leverage (gearing) ratio: D/V = D/(D+E)
What is MM Irrelevance proposition 1?
The value of a firm is unaffected by its capital structure
What is the formula for expected return on assets with unlevered equity?
r_e = r_a + (r_a - r_d)D/E
What is MM irrelevance proposition 2?
The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the debt-equity ratio
