Capital Structure Flashcards
Capital Structure
What two sources of financing are there?
Internal capital and external capital
Give an example of financing with internal capital
Retained earnings, which are profits not payed back to shareholders but used to finance investment, current expenses etc. (usually not enough for a firm)
What are the two sources of external capital financing?
Debt (no voting rights but senior claim to equity, compensated with interest)
Equity (voting right but no seniority claims, compensated with dividend)
What is the formula for Academic Leverage?
Debt / Total Assets
What is the formula for Industry Leverage?
Debt / EBIT
What are the 4 assumptions for the MM Theorem?
- Perfect capital markets (competitive, frictionless, rational agents)
- All agents have the same information
- No bankruptcy costs
- No taxes
Name the 4 original MM propositions.
- A firm’s total market value is independent of its capital structure.
- A firm’s cost of equity increases with its debt-equity ratio.
- A firm’s total market value is independent of its dividend policy.
- Individual investors are indifferent to all firms’ financial policies.
Explain the first MM Proposition.
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!
Explain the second MM proposition.
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!
Why is equity riskier than debt?
- Debt is senior to equity; interests and principal payment have to be made before any cash is distributed to shareholders.
- 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.
Explain the fourth proposition.
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.
When taxes are included in capital structure, what advantage does debt have?
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.
What is the formula of the tax shield?
PV of Tax Shield = Debt * Tax Rate
What tool can be used to subsidize equity and what effect does it have?
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.
What empirical strategy is used with the NID research?
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.