Capital Structure Flashcards
Corporate Finance (2/6) (24 cards)
What is Capital Structure?
The mix of sources of funds that companies use to fund their operations.
What are the two basic sources of funds?
Debt and Equity
Are all companies subject to business risk?
Yes.
What is business risk?
The variability of future cash flows if the company is financed only by equity.
What is financial risk?
The variability of future cash flows if the company is financed by debt.
What is financial leverage?
Taking on risk through borrowing to increase the rate of return earned by shareholders.
At what point is a company in financial distress?
When it has difficulty meeting its commitments to lenders.
What are some Direct financial distress costs of bankruptcy?
Fees paid to lawyers, accountants, liquidators.
What are some Indirect financial distress costs of bankruptcy?
Lost sales and reduced operating efficiency.
What increases the probability of Bankruptcy Costs?
Borrowing.
What is the probability of bankruptcy related to?
The company’s business and financial risk.
When liquidating a company who bears the realised liquidation costs?
Lenders.
When liquidating a company who bears the expected liquidation costs?
No, they seldom do.
What are some Indirect Costs of Financial Distress?
Loss of sales, loss of quality staff, loss of customers, loss of suppliers, loss of reputation.
How do Indirect Costs affect Financing Decisions?
Pressures for lower debt financing to reduce risk of these costs.
When do agency costs arise?
When a company enters into contractual relationships with various parties.
What is Claim dilution?
When holders of old debt have a less secure claim on a company’s assets due to them taking on new debt that ranks higher.
What is Asset substitution?
Using debt instead of Equity to undertake risky investments.
Why can Asset substitution be a problem?
The incentive might be so strong that a company may invest in wealth-destroying negative NPV projects.
When does Underinvestment occur?
When a company rejects low-risk investments with a positive NPV.
How do lenders react to management acting in the interest of shareholders?
They request higher interest rates or require covenants on borrowing, dividend payments, and investment projects.
How does borrowing impact management decisions?
Applies pressure to behave optimally as the company is obliged to meet interest payments.
What is the pecking order of finance sources?
- Internal Finance
2. External Finance - Where borrowing takes priority over issuing shares.
What does Information Asymmetry refer to?
Management tends to know much more about a company than shareholders.
