Finance 300 Final Exam

Front 1

whats capital structure

Back 1

its a mix of financial securities used to finance a firms activities

Front 2

another word for debt

Back 2

financial leverage

Front 3

a fraction of financing is represented by _____

Back 3

debt

Front 4

financial leverage in a firm's capital structure is important because _______

Back 4

it affects the value of the firm

Front 5

managers at a firm choose capital structure so that ____________

Back 5

the mix of securities making up the capital structure minimizes the cost of financing the firms activities

Front 6

Midigliani and Miller Prop 1 states that the capital structure decisions a firm makes will have no effect on the value of the firm IF:

Back 6

1. there are no taxes
2. there are no information or transaction costs
3. the real investment policy of the firm is not affected by its capital structure decisions

Front 7

real investment policy of the firm includes:

Back 7

criteria that the firm uses in deciding which real assets/projects to invest in

Front 8

the combined value of equity and debt claims does not change when you change the capital structure of the firm if no one other than the stockholders and the debt holders are receiving cash flows

Back 8

What Modigliani and Miller Prop 1 essentially states

Front 9

financial reconstructing

Back 9

a combination of financial transactions that occur to change the capital structure of the firm without affecting its real assets

Front 10

Modigliani and Miller Prop 2 states:

Back 10

the cost of a firms (required return on) common stock is directly related to the debt-to-equity ratio

Front 11

the value of the Modigliani and Miller analysis is that it tells us:

Back 11

exactly where we should look if we want to understand how capital structure affects firm value and cost of equity

Front 12

if financial policy matters it is because of three things

Back 12

1. taxes matter
2. information and transaction costs matter
3. capital structure choices affect a firm's real investment policy

Front 13

a benefit from including debt in a firms capital structure is

Back 13

firms can deduct interest payments for tax purposes but cannot deduct dividend payments

Front 14

the perpetuity model assumes that:

Back 14

1. the firm will continue to be in business forever
2. the firm will be able to realize the tax savings in the years in which the interest payments are made
3. the firms tax rate will remain constant

Front 15

debt incentivizes managers

Back 15

to focus on maximizing the cash flows that the firm produces since interest and principal payments must be made when they are due

Front 16

financial managers want to add debt:

Back 16

just to the point at which the value of the firm is maximized

Front 17

bankruptcy costs are also called

Back 17

costs of financial distress

Front 18

bankruptcy costs are costs

Back 18

associated with financial difficulties that firm might get into because it uses too much debt financing

Front 19

firms can incur bankruptcy costs

Back 19

even if they never actually file for bankruptcy

Front 20

Direct Bankruptcy Costs

Back 20

are out-of-pocket costs that a firm incurs as a result of financial distress

includes fees paid to lawyers, accountants, and consultants

Front 21

Indirect Bankruptcy Costs

Back 21

are costs associated with changes in the behavior of people who deal with a firm in financial distress

Front 22

some of a firm's (who is undergoing bankruptcy costs) potential customers will decide to purchase a competitor's products because of:

Back 22

1. concerns that the firm will not be able to honor its warranties
2. parts or service will not be available in the future

Front 23

for firms in debt investors:

Back 23

demand a lower price to compensate for the risk

Front 24

agency costs

Back 24

result from conflicts of interest between principals and agents.

principal entrusts/delegates its decision making authority to an agent

Front 25

agents are expected to

Back 25

act in the interest of the principal, but sometimes agents have interest conflicts with principals

Front 26

Stockholder-Manager Agency Costs

Back 26

the extent of the incentives of the managers are not perfectly identical to those of the stockholders, so managers will make some decisions that benefit themselves at the expense of the stockholders

Front 27

debt financing can do what to agency costs?

Back 27

reduce it because it incentivizes managers to max cash flow that the firm produces and limits the ability of bad managers wasting money on negative NPV projects

Front 28

debt financing can also increase agency costs by:

Back 28

altering the behavior of managers who have high proportion of their wealth riding on the success of the firm, through their stock holdings, future income, and reputations

Front 29

use of debt increases

Back 29

the volatility of the firms earnings and probability that the firm will get into financial difficulty

Front 30

Stockholder-Lender Agency Costs

Back 30

investors lend money to a firm and delegate authority to stockholders to decide how that money will be used

Front 31

Lenders in a stockholder-lender agency agreement protect themselves agaisnt stockholders acting in their own self interest by

Back 31

including provisions in the lending agreements that limit the ability of stockholders to pay dividends and conduct other behavior.

isnt foolproof though.

Front 32

Asset substitution problem

Back 32

once a loan has been made to a firm, the stockholders have an incentive to substitute less risky assets for more risky assets such as negative NPV projects

Front 33

Underinvestment problem

Back 33

occurs in a financially distressed firm when the value that is created by investing in a positive NPV project is likely to go to the lenders instead of the stockholders, therefore the firm forgoes financing and undertaking the project

Front 34

Trade-off theory

Back 34

managers choose a specific target capital structure based on the trade-offs between the benefits and the costs of debt.

managers will increase debt to the point at which costs and benefits of adding an additional dollar of debt are exactly equal because this is the capital structure that maximizes the firm value

Front 35

Pecking Order Theory

Back 35

different types of capital have different costs. managers choose the least expensive capital first then move to increasingly costly capital when the lower-cost sources of capital are no longer available

Front 36

cheapest source of capital (based on pecking order theory)

then the second cheapest?

Back 36

cash on hand or internally generated funds

debt is more costly to obtain than internally generated funds but is still relatively inexpensive

Front 37

most expensive source of capital (based on pecking order theory)

Back 37

raising money by selling stock

Front 38

when researchers compare the capital structures in different industries they find evidence that:

Back 38

supports the trade off theory

Front 39

some researchers argue that on _________ the trade off theory suggests they be

Back 39

average, debt levels appear to be lower than

Front 40

the more ____a firm is the less ____ it tends to have, which is exactly the opposite of what _____ we should see

Back 40

profitable; debt; trade-off theory

Front 41

based on what theory do public firms, in an average year, actually repurchase more shares than they sell?

Back 41

pecking order theory

Front 42

Pecking order theory and trade-off theory offer insights into:

Back 42

how managers choose the capital structure for their firms but neither is able to explain all of the capital structure choices we observe

Front 43

________ is an important consideration in many capital structure decisions

Back 43

financial flexibility

Front 44

managers must make sure they retain sufficient financial resources in the firm to take advantage of:

Back 44

unexpected opportunities as well as unforeseen problems