Capital Structure II Flashcards
(16 cards)
What is the trade-off theory?
It balances tax benefits of debt against bankruptcy and agency costs.
What does the pecking order theory suggest?
Firms prefer internal financing, then debt, and issue equity as a last resort.
What is the asset substitution problem?
Shareholders may prefer riskier projects when a firm is near bankruptcy.
What are non-tax influences on capital structure?
Non-tax factors that influence capital structure include:
Bankruptcy costs
Asymmetric information
Agency costs
Nature of a firm’s assets
What is financial distress?
Financial distress occurs when a firm struggles to meet its debt obligations. It is not the same as bankruptcy but may lead to it if the firm fails to recover.
What are bankruptcy costs?
Direct costs: Legal, administrative, and accounting fees (typically 3–4% of asset value).
Indirect costs: Lost customers, damaged reputation, and management distraction (can be 10–20% of firm value).
Together, these costs reduce the benefits of debt.
What is the trade-off theory of capital structure?
Firms balance the tax benefits of debt against the expected costs of financial distress.
Optimal capital structure is where marginal tax benefit = marginal bankruptcy cost.
What is asymmetric information?
Asymmetric information exists when managers know more than investors.
This creates problems like investors interpreting equity issuance as a signal that the stock is overvalued.
What is the pecking order theory?
Firms prefer to finance projects in the following order:
Internal funds (retained earnings)
Debt
New equity
This order minimises adverse selection problems due to asymmetric information.
Managers exhaust their internal funds first and then go for external debt. Once it is exhausted they go for hybrid source of capital and then finally the cost of equity will be the last resort to raise capital.
What is the asset substitution problem?
When near bankruptcy, shareholders may encourage riskier projects, even if they have negative NPV, because they benefit if the firm succeeds, while debtholders bear most of the loss if it fails.
What is the underinvestment problem?
A firm with high debt may pass up positive NPV projects because new equity raised would benefit debt holders more than shareholders, leading shareholders to reject the investment.
What is the debt overhang problem?
Debt overhang occurs when a firm’s existing debt discourages new equity investment in profitable projects. Shareholders refuse to fund projects where gains would mostly go to debtholders.
What is the free cash flow problem?
When managers have excess cash, they might waste it on unprofitable projects or perks instead of returning it to shareholders.
Solution: Use debt to discipline managers (forcing regular interest payments), or pay dividends.
How do tangible vs intangible assets affect leverage?
Tangible assets (e.g., real estate, machinery) can serve as collateral → support higher debt.
Intangible assets (e.g., brand, patents) are harder to value or sell → riskier for lenders, so less debt is used.
How do general-use vs firm-specific assets influence debt capacity?
General-use assets retain value across firms → more acceptable as loan collateral.
Firm-specific assets may have low resale value → lower borrowing capacity.
Summary of agency costs in capital structure?
Agency conflicts arise between:
Shareholders vs debtholders (asset substitution, underinvestment)
Managers vs shareholders (free cash flow problem)
Capital structure can help mitigate these conflicts by aligning incentives.
