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Corporate Finance > Week 2 > Flashcards

Week 2 Flashcards

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1
Q

What is MM Proposition I (no taxes)?

A
  1. Value of the levered firm = value of the unlevered firm
  2. Through homemade leverage individuals can undo the effects of leverage
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2
Q

In creating homemade leverage, how can you unlever and how do you lever?

A
  1. To unlever a position, sell shares and lend the proceeds
  2. To lever a position, buy shared with borrowed money
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3
Q

What is MM Proposition II (no taxes)

A

Expected return on equity is positively related to leverage becuase risk to equityholders increases with leverage

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4
Q

Why is the value of levered firm higher than the value of the unlevered firm?

A

The levered firm will pay less taxes then the all-equity firm because the levered firm has to pay interest to debtholders which is tax deductible

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5
Q

Why do bankruptcy costs lower firm value

A

The possibility of bankruptcy has a negative effect on firm value tue to the costs associated with bankruptcy that will lower the value of the firm. Shareholders will bear theses additional costs

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6
Q

What three selfish strategies increase agency costs?

A
  1. Incentive to take large risks
  2. Incentive towards underinvestment
  3. Milking the property
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7
Q

What is the selfish investment strategy: Incentive to take large risks?

A

Firms will pursue high-risk projects to maximize shareholder value when in financial distress. This behaviour expropriates value for bondholders

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8
Q

What is the selfish investment strategy: incentive towards underinvestment?

A

Unlevered firms will always invest in projects if NPV >0, nut levered firm may deviate because shareholder will bear most, if not all of the costs, while bondholders will capture most of the value.

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9
Q

What is selfish investment strategy: Milking the property?

A

Paying out additional dividends to leave less in the firm for bondholders. This is in favour of shareholders.

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10
Q

What are protective covenants?

A

These are agreements between share- and bondholders to reduce interest rates. The should reduce bankruptcy costs and thus increase firm value. They are the lowest-cost solution to shareholder-bondholder conflict. They can be both negative and positve of nature

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11
Q

What are positive protective covenants?

A

These types of agreements specify an action the company agrees to take / condition to abide by

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12
Q

What are negative protective covenants?

A

These types of covenants limit the actions a company may take

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13
Q

What four sources does CF go to?

A
  1. Payment to shareholders
  2. Payment to bondholders
  3. Government
  4. Layers etc.
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14
Q

What is the difference between marketable and non-marketable claims?

A

Marketable claims can be bought and sold in financial markets

Non-marketable claims cannot

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15
Q

What is the Free Cash Flow hypothesis?

A

Increase in dividends benefits shareholders by limiting the ability of managers to pursue wasteful activities. Principal and interest (debt) have even greater effect on this.

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16
Q

What is the market timing theory?

A

This theory states that equity will be issued when the market price is high compared to book value and debt is issues when market price is low relative to book value

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17
Q

Name three emperical regularities in regards to capital structure?

A
  1. Most corporations have low debt-asset ratios
  2. A number of firms use no debt
  3. Many corporations employ target debt-equity ratio
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18
Q

Name five important considerations for determining a target D/E ratio?

A
  1. Taxes (tax shield improves profitability
  2. Types of assets; large portion in tangible assets reduces financial distress costs
  3. Uncertainty of operating income: higher uncertainty increases financial distress –> less debt
  4. Peerfirms influence capital structure; peer effects. Mostly small firms following larger firms
  5. Capital structures are unstable over time; they cahnge based on variety of factors, expect for low leverage firms
19
Q

What does the tradeoff theory state?

A

Tradeoff theory descirbes how a firm shold optimize its capital structure in a world with taxes and bankruptcy. It states firms constantly balance their costs and benefits of debt in pursuit of the optimal D/E ratio

20
Q

Name three benefits of debt

A
  1. Tax liability reduction
  2. Reduction wasteful discretionary spending
  3. Banks monitor managers more efficiently
21
Q

What are the drawbacks of debt?

A
  1. Costs of financial distress
  2. Agency costs of underinvestment, incentive to focus on risky projects
  3. Personal tax costs (Ti > Tc)
22
Q

What are the different types of bankruptcy costs?

A

These bankruptcy costs are always paid before bondholders are paid. Two different types: direct and indirect.

Direct costs: legal and administrative costs, PV of delays in payouts. Small portion of total costs

Indirect costs:
1. Loss in revenue due to customer reluctancy
2. Suppliers want instant cash, which requires higher NWC.
3. Difficulty in raising capital –> forego fine investment opportunities

23
Q

What is the agency cost of debt?

A

Increasing shareholder wealth at the expense of bondholders.

24
Q

What is the agency costs of equity?

A

Decreasing shareholder wealth in advantage of bondholders

25
Q

Name the four essential points of the tradeoff theory?

A
  1. Use of debt is beneficial as firm value will increase with leverage
  2. The value of the firm will decrease past an optimal point of debt due to costs of debt
  3. Optimal leverage is firm-specific, determined by indirect and direct costs
  4. Costs of debt can be reduced through protective convenants, which lead to default if violated.
26
Q

What does the pecking order theory state?

A

This theory tries to explain capital structure choices made by firms. It’s a behavioral theory that poses the question whether firms should issue debt or equity first?

27
Q

Which hierarchy should firms use to fund investments according to the pecking order theory?

A
  1. Use FCF first. Using retained earnings is an independent decision
  2. Issue debt: First offer cllateralised securities. Firm signals that it believes in a project and that it doesn’t perceive a large increase in bankruptcy costs
  3. Issue equity: only issue shares if the firm exhausts debt capacity
28
Q

Explain why equity should be the last resort for firms to fund their investments

A
  1. Asymmetric information; managers have access to different information than investors. Markets are thus semi-efficient (inside information has value). Part of communication betwene managers and investors is conducted through signalling. Increasing leverage is a credible signal since company is willing to provide some collateral. Issuing equity is not a credible signal and is associated with the adverse selection process.
29
Q

What is adverse selection?

A

Bad quality category drives out good quality category

30
Q

What are the implications of the pecking order theory?

A
  1. There is no target amount of leverage
  2. Profitable firms use less debt
  3. Firms like financials flexibility
  4. Observed leverage is shaped by investment opportunities
31
Q

Why would investors prefer the use of isolationist valuation?

A

Because they assume the markets make mistakes and they prefer to calculate value on their own

32
Q

Why would investors prefer the use of relative valuation?

A

Investors assume markets make mistakes on individual cases but are correct on average

33
Q

Name three assumptions of the WACC method?

A
  1. Assumes a constant D-E ratio
  2. Assumes constant perpetual tax rate
  3. Changes in D/E ratio changes risks associated with CF and will impact return expected
34
Q

When is the WACC method an appropriate method?

A
  1. Analyzing a snapshot
  2. Constant D/E ratio thorughout multiple periods
  3. Firms in a steady state (constant leverage ratio / costly capital structure)
35
Q

What is the problem of the WACC method?

A

Doesn’t really show where the value is coming form (the project or the capital structure)

36
Q

What are the four types of financing side effects?

A
  1. Tax shield of debt
  2. Cost of issuing new securities (bankers, lawyers etc.)
  3. Cost of financial distress: possibility of financial distress imposes costs
  4. Subsidies to debt financing: yield on gvmt debt can be substantially below the yield of taxable debt. Adds value
37
Q

What is the general rule of valuation method selection?

A
  1. Use WACC or FTE if firm’s target D/E ratio applies to project over its life.
  2. Use APV if the project’s level of debt is known over the life of a project.

Exemptions:
In PE transactions, the debt level is reduced based on predetermined schedule –> Use APV. Also, for lease-vs-buy decisions and situations involving tax subsidies and flotation costs

38
Q

What are the challenges in creating positive social value and environmental value?

A
  1. Incorporating SV & EV goals in objectives and strategy
  2. Move from static to dynamic perspectives
39
Q

What are the four different value models?

A
  1. Shareholder model maximizes shareholder value. Maximal value = Financial value
  2. Refined shareholder model: maximize V = Financial Value + bSV+cEV, where b and c are the weights of the social value and environmental value between 0 and 1
  3. Stakeholder model: maximizes stakeholder value. Max Value = Financial Value + b*SV, with b being a weight between 0 and 1
  4. Integrated model maximizes value for current and future stakeholders. Max value = Financial Value + SV +EV
40
Q

Give two reasons companies should follow integrated value?

A
  1. Ethical case: corporate responsibilty (license to operate)
  2. Business case: long-term value creation
41
Q

What is a license to operate?

A

This is based on consumer trust in you brand and reputation. When you ‘lose your license to operate’, consumers don’t want to you from your company anymore

42
Q

What are the driving forces behind the internalization of SV & EV?

A
  1. License to operate
  2. Regulation and taxation
  3. Technological advancement
  4. Customer preferences
  5. Employee preferences
43
Q
A

Corporate Finance (2 decks)

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