Unit 3: Part 2- Capital Structure

Question 1

What is a capital structure?

Answer 1

Capital structure is a mix of securities used to finance the company’s assets

Question 2

What happens when a firm issues debt?

Answer 2

When firm issues debt, it splits cash flows into 2 parts: fixed claim to debt holders & residual component to equity holders. Specifies control rights: assets belong to shareholders so long as payments to debt holders are maintained & in default, assets are transferred to debt holders

Question 3

When do firms tend to have more debt or more equity?

Answer 3

Where firms have a lot of capital intensive equipment & fixed assets etc. they tend to have both debt. Whereas firms that have intellectual property & not a lot of fixed assets, tend to have more equity.

Question 4

What are key contributions to maximising firm & shareholder value?

Answer 4

Key contributions to maximising firm & shareholder value: changes in capital structure benefit the shareholders if & only if, the value of the firm increases and managers should select the capital structure that they believe will have the highest firm value

Question 5

What are perfect market assumptions?

Answer 5

no taxes (corporate & personal) ortransaction costs and investors can borrow & lend at same rate to company), information asymmetry & incomplete contracting

Question 6

What did Modigliani and Miller (1958) proposition 1 argue?

Answer 6

MM (1958) argued that the market value of any firm is independent of its capital structure & this is known as the irrelevancy theory. It says that the value of a levered firm is the same as the value of an un-levered firm. The theory says that a firm cannot change its total value by splitting its cash flows into different streams. They argued that the value of a firm is determined by its real assets & not its finance

Question 7

What does MM proposition 11 (no taxes) say?

Answer 7

MM proposition ll (no taxes ) states that when we introduce debt into our capital structure this has an impact of making the equity a lot more riskier. This then raises expected rate of return on equity.

Question 8

What are the assumptions for MM proposition 1 & 11 (perfect markets- 1958)?

Answer 8

Where we have no taxes, no transaction costs & individuals & corporations can borrow at same rate (situation of perfect markets), we have the 2 following propositions: 1) VL=Vu & 11) Re=Ra+(D/E)(Ra-Rd) where Ra=cost of capital for an all equity financed firm

Question 9

What is the capital structure in imperfect markets?

Answer 9

personal & corporate tax, transaction costs (specific focus on costs of bankruptcy), incomplete contracting (conflicts between managers, shareholders & debt holders) & asymmetric information

Question 10

What does debt financing create?

Answer 10

creates a tax shield (reduction in taxable income by claiming allowable deductions such as mortgage interest and medical expenses)

Question 11

What can investors in geared/leveraged companies expect?

Answer 11

Investors in a leveraged company can expect the same earnings as those in an un-levered company & tax savings from debt due to interest payments being tax deductible, creates an incentive to use debt (tax shield)

Question 12

What does MM (1963- imperfect markets) say?

Answer 12

MM (1963) states that value increases linearly with debt

Question 13

What are the implications for capital structure in a world of imperfect markets?

Answer 13

capital structure becomes relevant (interest tax shields increase after-tax cash flow to equity holders & reduces tax payments to government) & optimal capital structure (100% debt financing despite increased risk to equity

Question 14

What are the results for MM (1963) proposition 1 & 11? (imperfect markets)

Answer 14

1) VL=Vu+tcD & 11) Re=Ra+(D/E)(Ra-Rd)(1-tc)

Question 15

What are limits to debt financing?

Answer 15

debt puts pressure on a firm because coupon payments (& repayment of the principal at maturity) are obligations, as well as bankruptcy costs/costs of financial distress

Question 16

What are indirect costs of bankruptcy?

Answer 16

impaired ability to conduct business (suppliers, customers, employees, investors, etc lose faith in business), loss of asset value in financial distress

Question 17

What are agency costs of debt?

Answer 17

conflicts between shareholders & debt holders

Question 18

What are Implications of costs of financial distress to optimal capital structure?

Answer 18

as the company takes on more debt (probability of bankruptcy increases, making assets less attractive & more likely to suffer costs of bankruptcy) and expected financial distress costs outweigh tax benefits of debt

Question 19

What are benefits & costs to debt?

Answer 19

Benefits= reduction in corporate taxes & agency costs of equity. Costs= costs of financial distress (direct & indirect costs of bankruptcy)

Question 20

What are direct costs of bankruptcy?

Answer 20

Direct costs of bankruptcy are generally legal & administrative costs: negotiating with debt holders in business, resolving disputes between different debt holders (& trial costs, expert witnesses, etc.)

Question 21

What does tax shield result in?

Answer 21

tax shield cause decreases in weighted average cost of capital but the more debt we have, bankruptcy costs increase which causes a rise in the WACC

Question 22

What are the predictions from the trade-off model?

Answer 22

firms will have a ‘target’ debt ratio (minimise the WACC). Varies depending on the firm industry: leverage increasing with taxable profits & asset tangibility. Leverage decreasing with growth opportunities, volatility of operating cash flow & non-debt shields

Question 23

What are the problems with the trade-off model?

Answer 23

many profitable firms have little debt, there is no perfect model to predict financial distress costs (making it difficult to determine exactly what optimal debt levels are, the probability of financial distress & the magnitude of the cost after a firm is in distress)

Question 24

What are Information asymmetry, adverse selection & equity issues?

Answer 24

managers are better informed about the company than outside investors, managers will not issue equity where shares are undervalued & implications for market reaction to equity issuance

Question 25

What does signalling theory focus on?

Answer 25

Signalling theory focuses on information asymmetry. An issue of debt sends a credible message to the market regarding the company’s future prospects & capital structure depends on whether management perceive company to be under or over valued (debt issues sends a credible signal to the market & equity issues signals a poor signal to the market)

Question 26

What does signalling theory predict (even though evidence suggests otherwise)?

Answer 26

Signalling theory predicts undervalued companies have higher gearing ratios (debt-to-equity ratio) compared with overvalued companies & that the greater the information asymmetry problem, the higher the gearing ratio

Question 27

What is the Pecking Order Theory?

Answer 27

states that information costs are higher for equity than debt (follows theme of information asymmetry where one party to a transaction has more information compared to another). Issue securities subject to lowest level of asymmetric information first: 1. retained earnings/internal equity, 2. safe debt, 3. risky debt, 4. hybrid securities, 5. external equity

Question 28

What does Myers & Majluf (1984) argue that?

Answer 28

Myers & Majluf (1984) argued that a firm that issues equity suggests that a firm is potentially overvalued & managers are trying to take advantage of this

Question 29

What are the implications of Pecking Order theory?

Answer 29

no target/optimal debt ratio (capital structure is determined by financing needs), profitable firms use less debt & managers like financial slack (investors view equity offerings with scepticism & capital structure is managed to avoid issuing equity)

Question 30

What are the problems with pecking order theory?

Answer 30

‘dark side’ of financial slack, firms issue equity more frequently than predicted by pecking order & model assumes equity issuance to outside shareholders (collapses under a fully subscribed rights offering)

Question 31

What is the Market Timing Theory- Baker & Wargler (2002)?

Answer 31

a new view of capital structure. Argued that capital structure is driven by differentials between market & book valuations. Equity is issued when market values are high relative to book values & is repurchased when market values are low relative to book values. Says that firms tend to issue equity when investors are too optimistic about future earnings