25.2 Capital Structures Theories Flashcards
(46 cards)
What is MM Proposition I?
MM Proposition I states that under certain assumptions, the value of a firm is unaffected by its capital structure.
What are the assumptions leading to MM Proposition I?
- Capital markets are perfectly competitive.
- Investors have homogeneous expectations.
- There is riskless borrowing and lending.
- There are no agency costs.
- Investment decisions are unaffected by financing decisions.
How can MM Proposition I be intuitively explained?
MM I concludes that the value of a firm does not change depending on how the claims to its earnings are divided, similar to how the amount of pie available does not depend on how it is sliced.
What does MM Proposition II state?
MM Proposition II states that the cost of equity increases linearly as a company increases its proportion of debt financing.
Why does the cost of equity increase with debt financing according to MM Proposition II?
As the amount of debt increases, the residual cash flows to equity holders become more uncertain, increasing the risk and thus the cost of equity.
What is the relationship between cost of equity and debt-to-equity ratio in MM Proposition II?
The relationship is given by the formula: r_e = r_0 + (D/E)(r_0 - r_d), where r_e is the cost of equity, r_0 is the cost of equity with no debt, r_d is the cost of debt, and D/E is the debt-to-equity ratio.
What is the conclusion of MM II regarding WACC?
The conclusion is that the decrease in financing costs from using a larger proportion of debt is offset by the increase in the cost of equity, resulting in no change in the firm’s WACC.
What happens to firm value under MM with taxes?
Under MM with taxes, the value of a firm is maximized at 100% debt financing due to the tax shield provided by debt.
What is the formula for return on equity with taxes in MM II?
The formula is: r_e = r_0 + (D/E)(r_0 - r_d)(1 - T_C), where T_C is the tax rate.
What does the static tradeoff theory propose?
The static tradeoff theory seeks to balance the costs of financial distress with the tax shield benefits from using debt.
What is the optimal capital structure according to static tradeoff theory?
The optimal capital structure is the amount of debt financing at which the increase in the value of the tax shield is exceeded by the value reduction of higher expected costs of financial distress.
What are agency costs of equity?
Agency costs of equity are related to conflicts of interest between managers and owners, including monitoring costs, bonding costs, and residual losses.
What does the pecking order theory suggest?
Pecking order theory suggests that managers prefer to finance projects first with internal funds, then with debt, and finally with equity, based on the costs of asymmetric information.
What are residual losses in the context of noncompete agreements?
Residual losses may occur even with adequate monitoring and bonding provisions because such provisions do not provide a perfect guarantee.
What does the free cash flow hypothesis suggest about debt?
According to the free cash flow hypothesis, the use of debt forces managers to be disciplined with regard to how they spend cash because they have less free cash flow to use for their own benefit.
How does financial leverage affect agency costs?
Greater amounts of financial leverage tend to reduce agency costs.
What is pecking order theory?
Pecking order theory, based on asymmetric information, is related to the signals that management sends to investors through its financing choices.
What financing choices do managers prefer according to pecking order theory?
Managers prefer to make financing choices that are least likely to send negative signals to investors.
What is the hierarchy of financing choices in pecking order theory?
Financing choices follow a hierarchy based on visibility to investors: internally generated capital is most preferred, debt is the next-best choice, and external equity is the least preferred financing option.
What does pecking order theory imply about capital structure?
Pecking order theory implies that the capital structure is a by-product of individual financing decisions.
What is the formula for WACC?
WACC = [weight of debt × pretax cost of debt × (1 – tax rate)] + (weight of equity × cost of equity)
What internal factors affect a company’s capital structure?
Internal factors include the characteristics of the business, the company’s existing debt level, their corporate tax rate, and the company’s life cycle stage.
What external factors affect a company’s capital structure?
External factors include market and business cycle conditions.
What enhances a company’s ability to issue debt?
A company’s ability to issue debt is greater with predictable cash flows sufficient to make required debt payments, and with liquid tangible assets that can be pledged as collateral.
