Capital Structure Flashcards

Capital Structure

1
Q

What two sources of financing are there?

A

Internal capital and external capital

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

Give an example of financing with internal capital

A

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

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

What are the two sources of external capital financing?

A

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

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

What is the formula for Academic Leverage?

A

Debt / Total Assets

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

What is the formula for Industry Leverage?

A

Debt / EBIT

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

What are the 4 assumptions for the MM Theorem?

A
  1. Perfect capital markets (competitive, frictionless, rational agents)
  2. All agents have the same information
  3. No bankruptcy costs
  4. No taxes
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

Name the 4 original MM propositions.

A
  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.
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

Explain the first MM Proposition.

A

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!

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

Explain the second MM proposition.

A

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!

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

Why is equity riskier than debt?

A
  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.
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

Explain the fourth proposition.

A

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.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

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

A

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.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

What is the formula of the tax shield?

A

PV of Tax Shield = Debt * Tax Rate

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

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

A

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.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

What empirical strategy is used with the NID research?

A

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.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

What were the conclusions from the NID research?

A

Belgium introduced a subsidy to equity and this induced Belgian companies to increase their use of equity and decrease the use of debt.

17
Q

What are financial distress costs?

A

Costs arising from bankruptcy or distorted business decisions before bankruptcy.

18
Q

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

A

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”

19
Q

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

A

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.

20
Q

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

A

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

21
Q

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

A

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.

22
Q

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

A

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

23
Q

What is adverse selection?

A

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.

24
Q

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

A

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.

25
Q

What is debt maturity?

A

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

26
Q

What is maturity matching?

A

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.

27
Q

What are dynamic debt maturity choices?

A

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!!!)

28
Q

What is priority or seniority?

A

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.

29
Q

Give an overview of debt priority.

A

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.

30
Q

What are the parts of a typical loan agreement?

A

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.

31
Q

What are debt covenants?

A

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.

32
Q

What happens when a debt covenant is breached?

A

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

33
Q

What are negative debt covenants?

A

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

34
Q

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

A

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

35
Q

What four variables are used to empirically test capital structure and what are their effects?

A

Tangible assets - higher leverage because they have more collateral
Firms’ size (log sales) - bigger firms have more leverage because they are more diversified
Market to book ratio - high market to book ratio should lead to equity issuance
Profitability (return on assets) - higher profitability leads to lower leverage (Pecking order)

36
Q

Higher profitability leads to lower leverage, what would be an argument that justifies higher profitability to lead to higher leverage?

A

Disciplining effect of leverage on managers

37
Q

What is the effect of an airline route under threat and long term debt?

A

The more routes are under threat by low cost airlines, the longer the debt of established airlines because they expect bad states of the world.