Podcast
Questions and Answers
What is the primary goal of an optimal capital structure?
What is the primary goal of an optimal capital structure?
How does increased debt affect financial risk?
How does increased debt affect financial risk?
Which of the following factors contributes to business risk?
Which of the following factors contributes to business risk?
What effect does high business risk have on a firm’s optimal debt ratio?
What effect does high business risk have on a firm’s optimal debt ratio?
Signup and view all the answers
What role does the tax position of a firm play in capital structure decisions?
What role does the tax position of a firm play in capital structure decisions?
Signup and view all the answers
What is the relationship between risk and return in capital structure decisions?
What is the relationship between risk and return in capital structure decisions?
Signup and view all the answers
Which aspect primarily determines business risk?
Which aspect primarily determines business risk?
Signup and view all the answers
What is a consequence of poor capital structure?
What is a consequence of poor capital structure?
Signup and view all the answers
What is the primary benefit of using debt in a firm's capital structure according to the trade-off theory?
What is the primary benefit of using debt in a firm's capital structure according to the trade-off theory?
Signup and view all the answers
Which of the following is NOT considered a bankruptcy cost?
Which of the following is NOT considered a bankruptcy cost?
Signup and view all the answers
What situation would indicate an optimal capital structure within the trade-off theory?
What situation would indicate an optimal capital structure within the trade-off theory?
Signup and view all the answers
According to the signaling theory, what action should managers take if they believe their firm's stock is overvalued?
According to the signaling theory, what action should managers take if they believe their firm's stock is overvalued?
Signup and view all the answers
What is the preferred order of financing according to the pecking order theory?
What is the preferred order of financing according to the pecking order theory?
Signup and view all the answers
Which financing option is preferred first according to the order of preference?
Which financing option is preferred first according to the order of preference?
Signup and view all the answers
Which statement best reflects a consequence of high levels of debt in a firm's capital structure?
Which statement best reflects a consequence of high levels of debt in a firm's capital structure?
Signup and view all the answers
Which of the following factors decreases as a firm increases its debt ratio?
Which of the following factors decreases as a firm increases its debt ratio?
Signup and view all the answers
What is a reason for preferring retained earnings over external financing?
What is a reason for preferring retained earnings over external financing?
Signup and view all the answers
What might indicate that a firm's bankruptcy-related costs are starting to outweigh its tax benefits from debt?
What might indicate that a firm's bankruptcy-related costs are starting to outweigh its tax benefits from debt?
Signup and view all the answers
According to the content, what might investors typically prefer in terms of security?
According to the content, what might investors typically prefer in terms of security?
Signup and view all the answers
What is one possible interpretation when a company issues debt?
What is one possible interpretation when a company issues debt?
Signup and view all the answers
What does the herd theory indicate about capital structure?
What does the herd theory indicate about capital structure?
Signup and view all the answers
In benchmarking, what do businesses typically do?
In benchmarking, what do businesses typically do?
Signup and view all the answers
What is a significant factor influencing a manager's choice of financing source?
What is a significant factor influencing a manager's choice of financing source?
Signup and view all the answers
What may hinder high geared companies from obtaining further debt finance?
What may hinder high geared companies from obtaining further debt finance?
Signup and view all the answers
How does a 100% equity financed firm compare in tax liability to a 100% debt financed firm?
How does a 100% equity financed firm compare in tax liability to a 100% debt financed firm?
Signup and view all the answers
What effect does additional debt have on a firm that already has its income sheltered by tax-loss carry forwards?
What effect does additional debt have on a firm that already has its income sheltered by tax-loss carry forwards?
Signup and view all the answers
What is financial flexibility primarily concerned with?
What is financial flexibility primarily concerned with?
Signup and view all the answers
Why do lenders prefer to lend to firms with strong balance sheets?
Why do lenders prefer to lend to firms with strong balance sheets?
Signup and view all the answers
What characterizes conservative management styles?
What characterizes conservative management styles?
Signup and view all the answers
What did the Modigliani-Miller Irrelevance Theory suggest regarding a firm's value?
What did the Modigliani-Miller Irrelevance Theory suggest regarding a firm's value?
Signup and view all the answers
What assumptions did the Modigliani-Miller model use that contributed to its unrealism?
What assumptions did the Modigliani-Miller model use that contributed to its unrealism?
Signup and view all the answers
What is a consequence of increased debt for a firm?
What is a consequence of increased debt for a firm?
Signup and view all the answers
Study Notes
Capital Structure Theory
- Capital structure is the debt-to-equity composition used to finance a firm's operations.
- It's a key factor in maximizing firm value.
- Poor structure increases the cost of capital, reducing potential project NPVs and returns.
Optimal Capital Structure
- Optimal structure minimizes the overall cost of capital and maximizes firm value.
- A trade-off exists between risk and return. Increased debt raises bankruptcy risk for shareholders due to increased financial commitments.
- However, debt often carries a lower cost, boosting returns and therefore firm value.
Factors Affecting Capital Structure
- Financial Risk: The increased riskiness of a firm's stock due to debt introduction into its capital structure. It depends on the types of securities issued (more debt, more risk).
- Business Risk: The baseline riskiness of a firm's stock if it uses no debt. It is attributed to the firm's operations and determined by projections of returns on invested capital. Business risk varies across industries and changes over time based on factors such as sales uncertainty, output price volatility, and input cost fluctuations. Operating leverage—the extent to which operating costs are fixed—influences business risk. Higher business risk tends to lower optimal debt ratios for firms.
Firm's Tax Position
- Interest payments on debt are tax-deductible, incentivizing debt use.
- A 100% equity-financed firm pays more tax than a 100% debt-financed firm, all else equal.
- However, existing tax shields (e.g., tax loss carry-forwards) might reduce the value-adding effect of extra debt.
Financial Flexibility
- The ability of a firm to raise additional debt quickly and on favorable terms. It is crucial for capitalizing on emerging investment opportunities.
- Lenders prefer firms with strong balance sheets.
- Financial flexibility is determined by the steady supply of capital.
Managerial Conservatism/Aggressiveness
- Management philosophies influence capital structure choices.
- Some managers prefer certainty (conservative), while others are aggressive risk-takers.
- Debt is a risky capital instrument, committing the firm's future income and requiring compulsory interest and principal payments. Default incurs bankruptcy risk, impacting a firm's value.
- High returns from debt attract aggressive managers.
Capital Structure Theories
- Modigliani-Miller Irrelevance Theory: Early theory proposing firm value is unaffected by how capital is split between debt and equity; instead, valuation is driven by resource utilization efficiency. Assumes no taxes, bankruptcy costs, and information asymmetry between investors and managers, which makes the model unrealistic.
-
Traditional (Trade-Off) Theory: Firms aim to minimize capital cost and maximize value by considering taxes and bankruptcy costs. Tax savings from debt are weighed against the costs of potential bankruptcy. An optimal capital structure exists where the benefits of tax savings from debt are offset by the rising likelihood of bankruptcy costs.
- Bankruptcy costs include legal fees, accounting expenses, reputational damage, disruptions to operations, and higher interest rates on future debt.
- Signaling Theory: Managers possess better information about the firm's value than external investors. A firm might issue debt when it believes its stock is undervalued, and issue equity when belief in overvaluation. Debt issuance signals confidence in earning capacity, which might not be true as some managers might use the debt issuance as a ruse.
- Pecking Order Theory: Firms prefer using retained earnings first, followed by debt, and then equity to fund projects. It suggests that the source of financing is hierarchical. Retained earnings have low associated costs and are preferred due to fewer external financing costs. Debt is cheaper than equity, and debt issuance has a better signaling effect. Equity issuance is seen as a measure of last resort.
-
Behavioral Theories:
- Herd theory: companies tend to emulate industry capital structure to reduce uncertainty.
- Benchmarking: Firms adopt capital structures similar to industry leaders. However, this capital structure may not be optimal for firms with different investment opportunities
- Past experience: Managers use prior experience in choosing source of finance (debt/equity) to minimise financial distress.
Studying That Suits You
Use AI to generate personalized quizzes and flashcards to suit your learning preferences.
Related Documents
Description
Test your knowledge on capital structure theory, optimal capital structures, and the factors affecting a firm's financing decisions. This quiz explores how capital composition impacts firm value and the trade-offs between risk and return.
