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Flashcards in Capital Structure Deck (22)
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MM & Leverage

  • Leverage has NO BENEFIT for investors
  • with increasing leverage, the expected ROE increases 

Becuase: The systematic equity RISK increases at the same time 


  • WACC remains constant 


MM & financing Decisions

All financing decisions are ZERO NPV transactions and therefore do not create value 


WACC fallacy

TRUE: "cost of capital for debt is lower than for equtiy 

FALSE:... therefore more debt is better

  • Ignores differences in risk  



EPS fallacy 

TRUE: Leverage effects EPS 

FALSE: .. so it should be chosen to maximize EPS

  • ignores effect on equity risk 
    • The increase in EPS is necessary to compensate shareholders for the additional risk they are taking by the increased leverage 


Introduction of Taxes

Financing policy matters because it affects a fim tax bill

  • Debt increases firm value by reducing tax burden


Bankruptcy Cost:

Cost of financial Distress 

  • Direct cost
    • Legal expanses, ...
  • Indirect Cost 
    • Costs incurred before bankruptcy 


High level of debt are a disadvante because of the possibililty of financial distress 



(Asset Substituiton) 

  • Shareholder benefit from increase risk 
    • Debt holders bear the downside 
  • Firms will tend to liquidate assets to late and remain in buisness for to long 
  • Firms in distress will adopt excessively risky strategies to "gamble for resurrection"


The Cost of the risk-shifting problem

  • aufgrund höhere Zinsen 
  • shareholder bear the cost of (potential) risk shifting 


Ways around the risk-shifting problem

  • Commit to optimal low risk strategies 
  • Provide debt holders with assets as collateral 
  • Provide debt holders with control rights 


  • sometimes EQUITY is the only way to avoid the risk shifting problem 


Debt-overhang problem

  • shareholders may be reluctant to raise new funds or carry out new projects because most benefits would go to the firms existing creditors 


  • the old debt holders are the main geneficiaries of new capital 
  • Managment may forego profitable investment opportuinites 


Ways around the debt-overhang problem

  • raising SENIOR or Collateralised debt 
    • often prohibited by existing debt covenants
  • Additional Capital by existing debt holders
  • Reorganizing the firms existing financial structure 
    • Debt for Equity exchange
    • Debt forgiveness or resheduling 


It may be optimal to choose a low debt level to begin with 


Optimal Capital Structure

Trade Off: 

  • Value of Tax Shield 
  • and the expected Cost of debt 
    • cost of financial distress 
    • incentive problems 


Firms which are likely to enter financial distress and for wich the incentive problem are likely to be large should avoid too much debt 


Raising Equity Capital 

Firms that are overvalued

  • vorteilhaft neues EK aufzunehmen 


Raising Equity Capital 

Firms that are undervalued

  • unvorteilhaft neues EK aufzunehmen 
    • costly for the original shareholders 


Issuing Equity

  • Raising Capital may be interpreted as a negative signal about the firm prospects and the firm may not be able to raise external capital 

--> Issuing Equity signals bad news about the firm Value (ÜBERBEWERTET)

--> Announcing an Equity Issue results in a decrease in the market value of outstanding equity 


Pecking order Theory

When funding their investment needs firms will 

  • preferably use retained earnings
  • revert to debt as second financing source 
  • issue new equity as last resort


  • for existing shareholders, the same project is worth more when financed with internal rather than external risky funds
  • for existing shareholders, ....when financed with debt rather than equity 


Underinvestment Problem

  • Is larger in companies with less cash and more debt 
  • Aufgrund von Information Asymmetries 


Free Cash Flow Problem & Lösung

  • Holding Cash (for future investments) gives mangers to much flexibility 
  • Increases the potential conflicht with shareholders



  • Use debt 
    • reducing managers ability to pursue their own interests 
  • Provide managers with monetary incentives 




  • Obtain information and assure sound operating decisions 
  • Monitoring to reduce 
    • Incentive problems between different claimants
    • ...owners and managment 


Control rights

  • Voting rights to stockholders
    • fire CEO
    • approve stock repurchase /issues
    • approve large investmenst and M&A
  • Direct mechanisem to force managment to take certain actions 


Staged Investment

  • Providing only limited amounts of financing forces mangment to repeatedly acces the capital market 


Basic MM irrelevance Theorem

MM showed the irrelevance of the capital structure 

  • Financing decision are irrelevant for the firm value 
    • The value of the CF-Pie is not affected by how it is split up but rather by its total size
  • Value is created by OPERATING decisions only, not FINANCING decisions !!! 
  • All purely financing decisions are ZERO NPV transactions