Finance Final Ch. 15/21

Front 1

The impact of capital structure on value depends upon the effect of debt on ________ and _________.

Ch. 15/21

Back 1

1. WACC.
2. Free cash flow

Front 2

What is the effect of additional debt on WACC?

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Back 2

1. Debtholders have a prior claim on cash flows relative to stockholders
2. Firms can deduct interest expenses
3. Debt increases risk of bankruptcy
4. Adding debt increases the % of the firm financed with low-cost debt and decreases the % finance with high-cost equity

Net effect on WACC = uncertain

Front 3

What is the effect of additional debt on FCF?

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Back 3

1. Additional debt increases the probability of bankruptcy
2. Impact of indirect costs (NOPAT goes down, investment in capital goes up)
3. Additional debt can affect the behavior of managers

Front 4

What is asymmetic information and signaling?

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Back 4

Managers know the firm's future prospects better than the investors.

Managers would not issue additional equity if they thought the current stock price was less than its true value.

Hence, investors often perceive additional issuance of stock as a negative signal, and the price falls.

Front 5

What factors influence business risk?

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Back 5

1. Uncertainty about demand
2. Uncertainty about output prices
3. Uncertainty about input costs
4. Product and other types of liability
5. Degree of operating leverage

Front 6

What is operating leverage, and how does it affect a firm's business risk?

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Back 6

1. Operating leverage is the change in EBIT caused by a change in quantity sold.

2. The higher the proportion of fixed costs within a firm's overall cost structure, the greater the operating leverage.

Front 7

What is business risk?

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Back 7

1. Uncertainty in future EBIT
2. Depends on business factors such as competition, operating leverage, etc.

Front 8

What is financial risk?

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Back 8

1. Additional business risk concentrated on common stockholders when financial leverage is used
2. Depends on the amount of debt and preferred stock financing

Front 9

What must happen for leverage to be positive (increase expected ROE)?

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Back 9

BEP must be greater than Rd

Front 10

What is the MM I theory?

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Back 10

MM prove, under a very restrictive set of assumptions, including zero taxes, that a firm's value is independent of its capital structure.

Investment policy drives the firm.

Any increase in ROE resulting from financial leverage is exactly offset by the increase in risk, so WACC is constant.

Front 11

What is the MM II theory? 100% Debt Financing

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Back 11

Corporate tax laws favor debt financing over equity financing

With corporate taxes, the benefits of financial leverage exceed the risks: More EBIT goes to investors and less to taxes when leverage is used

More debt = higher firm value

Front 12

What is the Miller theory? Corporate and Personal Taxes

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Back 12

Personal taxes lessen the advantage of corporate debt

Corporate tax laws favor debt over equity. However, personal taxes favor equity because stocks provide a tax deferral and a lower capital gains tax rate. Personal taxes decrease the relative cost of equity and increase the relative cost of debt.

Thus, some advantages of debt financing are lost.

Front 13

What is the rule of thumb in relation to the MM I, MM II, and Miller theories?

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Back 13

Add debt to the firm's capital structure until the marginal benefit of the tax savings equals the marginal cost of expected financial distress.

Front 14

What are agency costs and how do they arise?

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Back 14

1. Bondholders are the principals and stockholders (owners) are the agents
2. The use of debt encourages perverse stockholder behavior (investing in risky projects)
3. Thus, stockholders must be monitored and bondholders require protective covenants
4. Agency costs increase the cost of debt and reduce its advantages

Front 15

How do you alleviate the agency problem?

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Back 15

Debt can help alleviate the agency problem by decreasing FCF and disciplining managers to avoid non-value adding acquisitions

However, debt can also lead to an "underinvestment" problem where managers avoid risky projects even if they have positive NPVs

Front 16

What is the trade-off theory?

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Back 16

1. Recognizes that target debt ratios exist and may vary among firms
2. Explains industry differences in capital structure

However, most firms with high, stable operating income have low debt ratios, which can lead to overinvestment in marginal projects

Front 17

Why do we use the trade-off theory?

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Back 17

MM theories ignore bankruptcy (financial distress) costs, which increases as more leverage is used

Firms with less (more) business risk can afford more (less) financial risk

An optimal capital structure exists that balances bankruptcy costs with tax benefits

Front 18

What is the pecking order theory?

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Back 18

1. Firms follow a specific financing order: internal financing, draw on short term financial options, issue new debt, issue new common stock (only as a last resort)
2. Suggest that firms with high operating (FCF) income should have little debt (low debt ratios)
3. May lead to the underinvestment problem in high growth companies
4. Supported by the fact that firms with a history of profitability tend to use less leverage
5. Not supported by the lack of short term debt financing that companies actually use

Front 19

What is the signaling theory?

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Back 19

MM assumed that investors and managers have the same information. But managers have better information (asymmetric). Thus, it is assumed that managers sell stock if it is overvalued, and/or sell bonds if they are undervalued.

Investors view stock sales as a negative signal