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44 Cards in this Set

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  • Back
whats capital structure
its a mix of financial securities used to finance a firms activities
another word for debt
financial leverage
a fraction of financing is represented by _____
debt
financial leverage in a firm's capital structure is important because _______
it affects the value of the firm
managers at a firm choose capital structure so that ____________
the mix of securities making up the capital structure minimizes the cost of financing the firms activities
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:
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
real investment policy of the firm includes:
criteria that the firm uses in deciding which real assets/projects to invest in
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
What Modigliani and Miller Prop 1 essentially states
financial reconstructing
a combination of financial transactions that occur to change the capital structure of the firm without affecting its real assets
Modigliani and Miller Prop 2 states:
the cost of a firms (required return on) common stock is directly related to the debt-to-equity ratio
the value of the Modigliani and Miller analysis is that it tells us:
exactly where we should look if we want to understand how capital structure affects firm value and cost of equity
if financial policy matters it is because of three things
1. taxes matter
2. information and transaction costs matter
3. capital structure choices affect a firm's real investment policy
a benefit from including debt in a firms capital structure is
firms can deduct interest payments for tax purposes but cannot deduct dividend payments
the perpetuity model assumes that:
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
debt incentivizes managers
to focus on maximizing the cash flows that the firm produces since interest and principal payments must be made when they are due
financial managers want to add debt:
just to the point at which the value of the firm is maximized
bankruptcy costs are also called
costs of financial distress
bankruptcy costs are costs
associated with financial difficulties that firm might get into because it uses too much debt financing
firms can incur bankruptcy costs
even if they never actually file for bankruptcy
Direct Bankruptcy Costs
are out-of-pocket costs that a firm incurs as a result of financial distress

includes fees paid to lawyers, accountants, and consultants
Indirect Bankruptcy Costs
are costs associated with changes in the behavior of people who deal with a firm in financial distress
some of a firm's (who is undergoing bankruptcy costs) potential customers will decide to purchase a competitor's products because of:
1. concerns that the firm will not be able to honor its warranties
2. parts or service will not be available in the future
for firms in debt investors:
demand a lower price to compensate for the risk
agency costs
result from conflicts of interest between principals and agents.

principal entrusts/delegates its decision making authority to an agent
agents are expected to
act in the interest of the principal, but sometimes agents have interest conflicts with principals
Stockholder-Manager Agency Costs
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
debt financing can do what to agency costs?
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
debt financing can also increase agency costs by:
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
use of debt increases
the volatility of the firms earnings and probability that the firm will get into financial difficulty
Stockholder-Lender Agency Costs
investors lend money to a firm and delegate authority to stockholders to decide how that money will be used
Lenders in a stockholder-lender agency agreement protect themselves agaisnt stockholders acting in their own self interest by
including provisions in the lending agreements that limit the ability of stockholders to pay dividends and conduct other behavior.

isnt foolproof though.
Asset substitution problem
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
Underinvestment problem
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
Trade-off theory
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
Pecking Order Theory
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
cheapest source of capital (based on pecking order theory)

then the second cheapest?
cash on hand or internally generated funds

debt is more costly to obtain than internally generated funds but is still relatively inexpensive
most expensive source of capital (based on pecking order theory)
raising money by selling stock
when researchers compare the capital structures in different industries they find evidence that:
supports the trade off theory
some researchers argue that on _________ the trade off theory suggests they be
average, debt levels appear to be lower than
the more ____a firm is the less ____ it tends to have, which is exactly the opposite of what _____ we should see
profitable; debt; trade-off theory
based on what theory do public firms, in an average year, actually repurchase more shares than they sell?
pecking order theory
Pecking order theory and trade-off theory offer insights into:
how managers choose the capital structure for their firms but neither is able to explain all of the capital structure choices we observe
________ is an important consideration in many capital structure decisions
financial flexibility
managers must make sure they retain sufficient financial resources in the firm to take advantage of:
unexpected opportunities as well as unforeseen problems