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
What 2 things give higher equity return?
- Higher leverage
- Lower debt return
What is the effect of leverage on a firm’s risk?
It does not affect the operational risk but it does affect the financial risk
What is leverage?
Leverage is essentially just debt
How can an investor undo the effect of leverage on their own account?
By investing in the equity of a leveraged firm and investing in debt such as T-bills on the investor’s own account
What 3 factors make capital structure irrelevant?
- If capital markets are efficient
- Each investor can borrow/lend on the same terms as the firm
- There are no tax benefits to debt
