FIN 438 EXAM 3 wku

Optimal capital structure we want:

- highest corporate value - lowest WACC - highest stock price per share

What are the two main agency problems in debt financing?

- managers can use corporate funds for non-value maximizing purposes -potential for underinvestment, the more debt a firm has the more likely for financial distress

indirect bankruptcy costs

-Larger than direct costs, but more difficult to measure and estimate. -Stockholders want to avoid a formal bankruptcy filing. -Bondholders want to keep existing assets intact so they can at least receive that money. -Assets lose value as management spends time worrying about avoiding bankruptcy instead of running the business. -The firm may also lose sales, experience interrupted operations and lose valuable employees

Direct Costs of Bankruptcy

-Legal and administrative fees -Ultimately cause bondholders to incur additional losses -Disincentive to debt financing

Financial Distress

-significant problems in meeting debt obligations -a situation where the firm either is close to bankruptcy or enters bankruptcy

Modigliani and Miller Study no taxes assumptions:

1. There are no brokerage costs. 2. There are no taxes. 3. There are no bankruptcy costs. 4. Investors can borrow at the same rate as corporations. 5. All investors have the same information as management about the firm's future investment opportunities. 6. Earnings before interest and taxes (EBIT) do not grow and are not affected by the use of debt.

MM Propositions: 3 situaitons

1. World without taxes 2. World with Corporate Taxes 3. World with corporate taxes & personal taxes

The result of Miller's work is the conclusion that the US Tax Code produces two competing pressures that affect a business's use of leverage.

1. the deductibility of INTEREST —which creates a tax shield—favors the use of DEBT financing in a firm's capital structure 2. the preferential tax treatment of EQUITY income (dividends and capital gains) favors the use of EQUITY financing.

What type of manager is more likely to use debt in an effort to boost profits?

An aggressive manager

WACC increases because

Bankruptcy and agency costs cause the costs of debt and equity to increase at an increasing rate.

MM Proposition II (no taxes)

Because Vu and VL are equal, their WACCs are equal The WACC does not depend on the debt to equity ratio and does not depend on capital structure

What are the benefits and costs in using debt instead of equity?

Benefits: tax benefits, adds discipline to management Costs: bankruptcy costs, agency costs, loss of future flexibility

Which one of the following is the risk that is most related to the daily operations of a firm?

Business risk

Once we include taxes in the MM PI and PII __________ ____________ definitely matters!!

Capital Structure

MM Proposition I (no taxes)

Capital structure is irrelevant. No taxes, transaction or bankruptcy costs

With external financing would you rather use debt or equity?

Debt

The costs of going bankrupt:

Direct cost: legal and other deadweight costs Indirect Cost: costs arising because people perceive you to be in financial trouble

According to the reserve borrowing capacity theory, a firm should use less equity and more debt financing than is generally recommended so that the firm can sell additional shares if it encounters a new investment opportunity.

False

Firms whose raw material and other input prices exhibit greater variability have less business risk, all other things being equal.

False

Based on your understanding of the trade-off theory, what kind of firms are likely to use more financial leverage?

Firms with a higher proportion of variable-versus-fixed costs Firms with stable earnings and less business risk have a better ability to service their debt.

Which one of the following makes the firms capital structure irrelevant?

Homemade leverage

MM Proposition I (with taxes)

If we now allow for taxes, the firm can increase its value by financing with debt. This is because debt allows the firm to pay less in taxes. Without taxes the firm does not benefit form financing with debt. VL is higher

Would you rather use internal(RE) or external financing?

Internal Financing

Which of the following states that a firms cost of equity capital is directly and proportionally related to the firms capital structure?

MM Proposition II

Market Timing Theory

Managers try to "time the market" when issuing securities; issue debt when stock market is 'low' and IR are low and issue equity when market is 'high'

What do firms look for in financing?

Managers value you flexibility and control!!

An optimal capital structure is characterized by two important attributes: First, it _____________ the firm's weighted average cost of capital, and second, it _____________ the value of the firm, which should make our shareholders very happy.

Minimizes, Maximizes

Does a repurchase have an effect on stock price?

No, the previous change in capital structure affects stock price.

Miller's Theory: Corporate and Personal Taxes

Personal taxes lessen the advantage of corporate debt: -Corporate taxes favor debt financing since corporations can deduct interest expenses. -Personal taxes favor equity financing, since no gain is reported until stock is sold, and long-term gains are taxed at a lower rate.

A leveraged buyout (LBO) helps the firm __________ both its excess cash flows and managers' temptation to incur wasteful expenses.

Reduce

a firm with a very positive outlook might tend to use debt financing beyond its normal target capital structure.

Signaling Theory

MM Proposition II (with taxes)

The cost of equity increases as the company increases the amount of debt in its capital structure, but the cost of equity does not rise as fast as it does in the no tax case.

Operating Leverage

The extent to which fixed costs are used in a firm's operations. If a high percentage of a firm's total costs are fixed costs, then the firm is said to have a high degree of operating leverage.

bait and switch

The strategy of raising funds through debt financing and investing the funds in riskier projects than anticipated by the lenders. Bondholders will require higher IR for firms that do this.

Static Theory of Capital Structure

The theory tries to balance the costs of financial distress with the tax shield benefit from using debt. Under this theory, there exists an optimal capital structure that is a combination of debt and equity.

As the D/E ratio increases, the probability of bankruptcy increases

True

The greater a firm's chance of bankruptcy, the Lower its optimal debt ratio will be.

True

The use of financial leverage increases a firm's expected ROE, increases the probability of a large loss, and consequently increases the risk borne by the firm's stockholders.

True

under-investment problem

a situation in which equity holders choose not to invest in a positive NPV project because the firm is in financial distress and the value of undertaking the investment opportunity will accrue to bondholders rather than themselves

Reserve Borrowing Capacity Theory

argues that managers should maintain lower levels of debt financing than would be generally recommended so as to have additional borrowing capacity available when it is needed.

Financial risk is:

dependent upon a company's capital structure.

the advantage of using a less-than-optimal level of debt is that it _____________ the firm's reserve borrowing capacity.

increases

According to the pecking order hypothesis, a profitable firm is ________ likely to use debt than a less profitable firm.

less

According to signaling theory, if managers expect the firm's stock price to decrease—even if the firm has a profitable investment opportunity—they should be ______ likely to raise capital through equity financing.

less, and should prefer to finance the new project with debt financing.

A basic premise of Miller's work, under the current US Tax Code, is that investors are willing to accept a ____________ pre-tax return on equity investments than on bond investments because tax rates imposed on

lower

As with all financial decisions, a firm should try to establish a capital structure that maximizes the stock price, or shareholder value. This is called the optimal capital structure; it is also the debt-equity mix that

minimizes the firm's weighted average cost of capital.

A firm may use debt and equity financing that differs from its targeted amounts if its business activities or its industry becomes...

more risky and more competitive

interest tax shield

tax savings resulting from the deductibility of interest payments

Recapitalization

that it should issue enough additional debt to optimize its capital structure, and then use the debt proceeds to repurchase stock.

trade-off theory

the firm picks its capital structure by trading off the benefits of the tax shield from debt against the costs of financial distress and agency costs

pecking order hypothesis

the idea that managers will prefer to fund investments by first using retained earnings(internal), then debt and equity only as a last resort. They use internally generated funds first because there are no floatation costs or mixed signals.

Business Risk

the risk a firm's common stockholders would face if the firm had no debt.

Signaling Theory

the use of leverage as a way to signal information to investors, asymmetric information. Investors understand that managers know more so they view new stock sales as a negative signal. Management would not want to issue new stock if future prospects look good.

Homemade leverage

the use of personal borrowing and lending to change the overall amount of financial leverage artificially themselves

Every firm has business risk, but only firms with debt have financial risk

true