Topic 9 - Capital Structure Flashcards
Capital Structure
the proportions of debt, equity and other securities that a firm has outstanding
Unlevered equity
equity in a firm with no debt
levered equity
this refers to having an ownership stake in a company that uses debt financing in its capital structure. when a company takes on debt it is levered because debt amplifys potential risk and potential return for equity holders
rWACC formula
rWACC =
(D / D+E) x rD + (E / D+E) x rE
is debt or equity cheaper
debt. however it raises the cost of capital for equity
MM proposition 1
In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.
home made leverage
When investors use leverage in their portfolios to adjust the leverage choice made by the firm.
if investors want a different capital structure than the one the firm has chosen they can borrow or lend om their own to achieve the same result.
MM proposition 2
This explains the relationship between a firms cost of capital, its leverage, and the risk of its assets.
The cost of capital of levered equity is the same as the cost of capital of unlevered equity plus a premium that is proportional to the market value debt to equity ratio
MM1 Formula
V^L = V^U
MM2 Formula
rE = rU + D/E (rU - rD)
interest tax shield + formula
the reduction in taxes paid due to teh tax deductibility of interest
Tax Shield = Corporate tax rate x interest payment
MM1 formula with tax
MM1 states that leverage increases a firms value due to the tax deductibility of interest payments. contrasting the original MM1 proposition.
V^L = V^U + PV (interest tax shield)
MM2 formula with tax
rE = rU + D/E (rU - rD) x (1 - Tc)
how does tax change company value
it reduces company value because some of it goes towards tax collectors. When we include debt in capital structure we pay interest which is tax deductible, which means we create a tax shield.
Trade-off theory
The firm picks its capital structure by trading off the benefits of the tax shield from debt against the cost of financial distress.
according to trade-off theory, the total value of a levered firm is the value of the firm without leverage plus the present value of the tax savings from debt capital, less the present value of financial distress costs
Trade off theory formula
V^L = V^U + PV(tax shield) - PV(Financial distress costs)
why not only use debt if we can avoid tax?
because the risk of bankruptcy is much higher if we only use debt capital. there is an optimal level of debt that should be used
pecking order hypothesis
managers will prefer to fund investments by first using retained earnings, then debt and equity only as a last resort
adverse selection
when one party in a transaction has better information than the other. this results in higher quality participants being driven out of the market by the lower quality ones.
how does adverse selection work (insurance example)
health insurance providers can’t perfectly assess the health of potential customers. people with higher health risks are more likely to buy insurance while healthier people may opt out due to higher premiums based on average risk.
the result of this is that the pool of insured people becomes disproportional riskier, driving premiums higher.
