Capital Structure Flashcards
(13 cards)
What is capital structure?
The mix of debt and equity used to finance a firm’s operations. Key factors include tax benefits of debt, financial distress risk, and ownership control.
Compare active vs. passive changes to capital structure.
Active: Intentional restructuring (e.g., issuing debt to buy back equity). Passive: Gradual changes (e.g., funding new projects with debt, altering the debt-equity ratio over time).
What is the Modigliani-Miller (M&M) Theorem in a ‘perfect world’?
In a world with no taxes, bankruptcy, or asymmetric information, capital structure does not affect firm value (V_L = V_U). WACC remains constant.
How does M&M Proposition II describe the cost of equity?
Cost of equity increases with leverage: i_E = i_{E,0} + rac{D}{E}(i_{E,0} - i_D). Shareholders demand higher returns for higher risk.
What changes when corporate taxes are introduced to M&M?
Debt becomes advantageous due to tax shields: V_L = V_U + DTC. Optimal structure shifts to 100% debt.
How do bankruptcy costs affect M&M with taxes?
Firm value balances tax shields and distress costs: V_L = V_U + DTC - Financial Distress Costs. Optimal debt level is now less than 100%.
What are costs of financial distress?
Loss of supplier/consumer confidence, tighter credit terms, employee attrition, and reduced partnership opportunities.
Which industries typically have high vs. low debt ratios?
High: REITs, casinos, auto dealerships (stable cash flows). Low: Biotech, semiconductors (volatile earnings).
What is the pecking order theory?
Firms prefer financing sources in this order: 1) Retained earnings, 2) Debt, 3) Equity (to avoid signaling overvaluation).
How does debt mitigate agency costs?
Debt reduces free cash flow, forcing managers to focus on repayments and avoid wasteful projects.
What real-world factors influence capital structure?
Tax rates, earnings stability, financial flexibility, credit ratings, and industry norms (per CFO surveys).
Why did Apple issue debt in 2013 despite having cash reserves?
To fund shareholder payouts tax-efficiently and exploit low interest rates (active capital structure management).
