Week 1

Question 1

What two sources of financing are there?

Answer 1

Internal capital and external capital

Question 2

Give an example of financing with internal capital

Answer 2

Retained earnings, which are profits not payed back to shareholders but used to finance investment, current expenses etc. (usually not enough for a firm)

Question 3

What are the two sources of external capital financing?

Answer 3

Debt (no voting rights but senior claim to equity, compensated with interest)
Equity (voting right but no seniority claims, compensated with dividend)

Question 4

What is the formula for Academic Leverage?

Answer 4

Debt / Total Assets

Question 5

What is the formula for Industry Leverage?

Answer 5

Debt / EBIT

Question 6

What are the 4 assumptions for the MM Theorem?

Answer 6

1. Perfect capital markets (competitive, frictionless, rational agents)
2. All agents have the same information
3. No bankruptcy costs
4. No taxes

Question 7

Name the 4 original MM propositions.

Answer 7

1. A firm’s total market value is independent of its capital structure.
2. A firm’s cost of equity increases with its debt-equity ratio.
3. A firm’s total market value is independent of its dividend policy.
4. Individual investors are indifferent to all firms’ financial policies.

Question 8

Explain the first MM Proposition.

Answer 8

A firm’s market value is independent of its capital structure! The value of a firm is determined by the Present Discounted Value of Future Cash Flows. When a firm issues debt and equity securities, it splits its cash flows into two streams; safe stream to bondholders and a risky stream to stockholders. The value of the firm is determined by the real assets on the left side of the balance sheet and has nothing to do with capital structure. The size of the pie matters, not how we slice it!

Question 9

Explain the second MM proposition.

Answer 9

A firm’s cost of equity increases with its debt-equity ratio! The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. If the WACC > Rd, Re is increasing with D / E because increasing the debt makes the equity riskier, increasing the expected returns investors of equity demand!

Question 10

Why is equity riskier than debt?

Answer 10

1. Debt is senior to equity; interests and principal payment have to be made before any cash is distributed to shareholders.
2. If the company is liquidated; debtholders have the right to a fixed claim - the amount of their debt, gains or losses are taken over by the shareholders.

Question 11

Explain the fourth proposition.

Answer 11

Individual investors are indifferent to all firms’ financial policies. Any combination of securities is as good as any other because the size of the pie (assets) doesn’t change, just the way an investor slices it. The morale is that managers should not care about the risk preferences of the investors.

Question 12

When taxes are included in capital structure, what advantage does debt have?

Answer 12

The interest can be deducted from the EBIT, which ensures a lower taxable income (EBT), which ensures a higher cashflow to all security holders. It is called tax shield.

Question 13

What is the formula of the tax shield?

Answer 13

PV of Tax Shield = Debt * Tax Rate

Question 14

What tool can be used to subsidize equity and what effect does it have?

Answer 14

The Notional Interest Deduction is an explicit equity deduction introduced in Belgium in 2006. This deduction reduces the favors of the use of debt financing through its interest deduction.

Question 15

What empirical strategy is used with the NID research?

Answer 15

Difference in differences analysis. The introduction of NID was treated as an experiment. Belgium is the treated country and Netherlands, Luxembourg, France and Germany are control countries.

Question 16

What were the conclusions from the NID research?

Answer 16

Belgium introduced a subsidy to equity and this induced Belgian companies to increase their use of equity and decrease the use of debt. The effect is particularly strong for small firms.

Question 17

What are financial distress costs?

Answer 17

Costs arising from bankruptcy or distorted business decisions before bankruptcy.

Question 18

Name the two categories of financial distress costs and name examples.

Answer 18

Direct costs; Legal and administrative costs

Indirect costs;
- Impaired ability to conduct business.
- selfish strategy 1; Incentive to take large risks
- selfish strategy 2; incentive toward underinvestment
- selfish strategy 3; “Milking the property”

Question 19

Describe Selfish Strategy 1 (Risk taking) when in Financial Distress.

Answer 19

Selfish stockholders accept negative NPV projects with large risks because if the gamble fails, the bondholders bear the risk. If the gamble wins, the stockholders make the gains.

Question 20

Describe Selfish Strategy 2 (Underinvestment) when in Financial Distress.

Answer 20

Selfish stockholders skip a positive NPV project when they have to invest extra money when the bondholders make the gains of the investment.

Question 21

Describe Selfish Strategy 3 Milking the Property when in Financial Distress.

Answer 21

The shareholders just pay out the remaining cash in dividends, leaving the firm insolvent with nothing for the bondholders, but plenty for the former shareholders.

Question 22

What is the effect of the integration of Taxes and Financial Distress costs on the Capital Structure?

Answer 22

There is a trade-off between the tax advantage of debt and the higher costs of financial distress with debt.

Question 23

What is adverse selection?

Answer 23

Think of Lemon Problem with used cars! Some used cars are peaches (good) and some are lemons (bad). The buyer cannot distinguish between which car is a peach or a lemon so he averages his willingness to pay. Therefore, the good cars which are actually worth more are priced out of the market and the bad cars remain in the market.

Question 24

How do companies deal with the problem of adverse selection which drives investors to pay less for stocks?

Answer 24

Pecking order theory;
Preferable use retained earnings (no asymmetric info problems)
Then borrow from debt market
As a last resort, issue equity.

This because external finance is more costly than internal funds and because debt is less costly than equity because it is less sensitive to asymmetric info.

Question 25

What is debt maturity?

Answer 25

Maturity determines the duration of the debt. When the debt matures, the borrower may either repay the lender or rollover the debt.

Question 26

What is maturity matching?

Answer 26

Firms should match the maturity of their liabilities to that of their assets. That reduces both the risk that cash flows from assets will be insufficient to repay the principal when debt matures before assets do and the risk of firms not being able to service future debt payments when assets have ceased to yield income.

Question 27

What are dynamic debt maturity choices?

Answer 27

Ideally, a firm should borrow short-term when it expects good states of the world and long-term when it expects bad states of the world (Brunnermeier and Yogo model) (Check Binary Tree in Slides!!!)

Question 28

What is priority or seniority?

Answer 28

Corporate debt structure typically includes claims that differ in their liquidation priority in the case of default. Such priority can be established by granting rights to collateral (security) and/or by including anti-dilutive provisions that prioritize payments.

Question 29

Give an overview of debt priority.

Answer 29

Senior debt and subordinated debt.
Senior debt has lowest interest, variable interest rate and is secured by all/most assets.
Subordinated debt has higher interest because it is less protected. It has a fixed interest rate and it is unsecured.

Question 30

What are the parts of a typical loan agreement?

Answer 30

The Note; specifies the principal and the interest and the timing of repayment.
Collateral; Specifies assets assigned and terms under which lender takes possession of assets.
Borrower guarantees; Promise by one party to assume the debt obligation of a borrower if that borrower defaults.
Events of Default; Exact conditions under which a loan is considered in default.
Covenants; Agreements between company and creditors that the company should operate within certain limits.

Question 31

What are debt covenants?

Answer 31

Agreements between a company and its creditors that the company should operate within certain limits. A company may, for example, agree to limit other borrowing or to maintain a certain level of leverage. Other common limits include levels of interest cover, working capital and debt service cover. Covenants can be changed if debt is restructured.

Question 32

What happens when a debt covenant is breached?

Answer 32

Most of the time, creditors can demand immediate repayment, or it can lead to a renegotiation of the terms of the debt.

Question 33

What are negative debt covenants?

Answer 33

Agreements that state what the borrower CANNOT do and positive covenants are agreements what the borrower MUST do.

Question 34

What happens to the capital structure after a violation of the debt covenant?

Answer 34

Strong negative effect on net debt issuance.
Not very strong effect on equity issuance.
Leverage ratio becomes significantly lower following a covenant violation.