Mastering Capital Structure
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Questions and Answers

What is capital structure?

  • The legal structure of a business
  • The mix of external funds used to finance a business (correct)
  • The management structure of a business
  • The physical structure of a business

What is financial leverage?

  • The use of debt to finance a business (correct)
  • The use of internal funds to finance a business
  • The use of equity to finance a business
  • The use of preferred stock to finance a business

What are leverage or gearing ratios used for?

  • To assess the amount of preferred stock in a company's capital structure
  • To assess the amount of debt in a company's capital structure (correct)
  • To assess the amount of internal funds in a company's capital structure
  • To assess the amount of equity in a company's capital structure

What is an optimal capital structure?

<p>One that minimizes the cost of debt and equity financing and maximizes the value of the firm (A)</p> Signup and view all the answers

What is the seniority of the capital structure?

<p>The order in which debt is paid in the event of bankruptcy (A)</p> Signup and view all the answers

What does the Modigliani-Miller theorem argue?

<p>In a perfect market, how a firm is financed is irrelevant to its value (A)</p> Signup and view all the answers

What does the trade-off theory of capital structure allow?

<p>Bankruptcy costs to exist as an offset to the benefit of using debt as a tax shield (C)</p> Signup and view all the answers

What does the pecking order theory state?

<p>Companies prioritize their sources of financing, preferring to raise equity as a financing means 'of last resort' (D)</p> Signup and view all the answers

What do capital structure arbitrageurs seek to profit from?

<p>Differential pricing of various instruments issued by one corporation (D)</p> Signup and view all the answers

Flashcards

Capital Structure

The combination of debt and equity a company uses to finance its operations.

Financial Leverage

The use of debt to finance a business, increasing financial risk but potentially boosting returns.

Leverage/Gearing Ratios

Ratios used to analyze a company's debt levels and its ability to meet obligations.

Optimal Capital Structure

The ideal mix of debt and equity that minimizes financing costs and maximizes firm value.

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Seniority of Capital Structure

The order in which debt holders are paid back in case of bankruptcy.

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Modigliani-Miller Theorem

In a perfect market, the way a company finances itself doesn't affect its value.

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Trade-off Theory of Capital Structure

This theory acknowledges that bankruptcy costs can offset the tax benefits of debt.

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Pecking Order Theory

Companies prefer to raise internal financing first, then debt, and only use equity as a last resort.

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Capital Structure Arbitrageurs

They exploit price differences in debt and equity securities issued by the same company to make a profit.

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Study Notes

Capital structure determines the mix of external funds (capital) used to finance a business, including shareholders' equity, debt, and preferred stock, and is detailed in the company's balance sheet.

Too much debt in relation to other sources of capital increases financial leverage, which can increase the risk of the company and reduce its financial flexibility, resulting in a greater cost of capital.

Various leverage or gearing ratios are closely watched by financial analysts to assess the amount of debt in a company's capital structure.

An optimal capital structure is one that is consistent with minimizing the cost of debt and equity financing and maximizing the value of the firm.

Once management has decided how much debt should be used in the capital structure, decisions must be made as to the appropriate mix of short-term and long-term debt.

In the event of bankruptcy, the seniority of the capital structure comes into play, with senior debt being paid first.

The Modigliani-Miller theorem argues that, in a perfect market, how a firm is financed is irrelevant to its value.

Trade-off theory of capital structure allows bankruptcy costs to exist as an offset to the benefit of using debt as a tax shield.

Pecking order theory states that companies prioritize their sources of financing, preferring to raise equity as a financing means "of last resort".

Capital structure arbitrageurs seek to profit from differential pricing of various instruments issued by one corporation.

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Description

How much do you know about capital structure? Test your knowledge with this quiz! From the optimal mix of debt and equity financing to the different theories and ratios used to assess a company's capital structure, this quiz will challenge your understanding of this important aspect of corporate finance. Keywords: capital structure, debt, equity financing, financial leverage, Modigliani-Miller theorem, bankruptcy, trade-off theory, pecking order theory, capital structure arbitrageurs.

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