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CTP - 7th Edition > Chapter 20 - The Capital Structure Decision and Management > Flashcards

Chapter 20 - The Capital Structure Decision and Management Flashcards

(134 cards)

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1
Q

Capital Structure

A

A firm’s mix of debt and equity financing

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2
Q

If you minimize the cost of capital, you will maximize what?

A

Shareholder value

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3
Q

Optimal Capital Structure

A

Mix of long-term debt and equity that produces the minimum weighted average cost of capital

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4
Q

A lower WACC will allow a firm to be what when it comes to investment opportunities?

A

More competitive

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5
Q

Characteristics of Long-Term Debt Financing
* Cost of Debt
* Tax Benefits of Debt
* Efficiency of Debt Markets
* Restrictions of Managerial Flexibility
* Greater Risk of Bankruptcy
* Monitoring Requirements

A

Cost of debt – debt financing is cheaper than the cost of equity

Tax benefits of debt – interest payments paid by corporations are generally tax deductible

Efficiency of debt markets – markets are efficient, especially for debt issues that are highly rated

Restrictions on managerial flexibility – payments must be made on time and debt can be accompanied by covenants

Greater risk of bankruptcy – an inability to make required debt payments may lead debt holders to force a firm into bankruptcy

Monitoring requirements – adhere to reporting requirements from the indenture or loan agreement

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6
Q

Two primary reasons debt financing is lower than equity financing

A

Debtholders come before equity holders in bankruptcy payouts, so they have a reduced risk and thus a lower premium to be paid

The amount paid is limited to the contractual coupon amount

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7
Q

Tax Shield

A

Tax deductibility of interest expense

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8
Q

Characteristics of Equity Financing
* Cost of Equity
* Managerial Flexibility ( e.g. dividends)
* Voting Rights
* Costs of Issuance
* Earnings Dilution
* Retained Earnings

A

Cost of equity – greater level of risk for equity holders and no tax benefit

Managerial flexibility – dividend payments are optional, though explicit or implicit dividend policies can sometimes be observed

Voting rights – extend voting rights and control to a wider group of people

Costs of issuance – cost of underwriting or issuing is expensive

Earnings dilution – increased financing from issuance of new stock will further dilute earnings

Retained earnings – reinvesting earnings is a much lower cost of equity financing

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9
Q

Most common example of a hybrid security

A

Convertible bond

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10
Q

Trade-Off Theory for Capital Structure

(and what the graph looks like)

A

Mixing debt and equity financing until the lowest WACC is obtained

Adding debt to a 100% equity financed entity would start to lower WACC

It would increase after time as increased debt means increased risk, of which equity holders would demand higher return and coupon rates on borrowings would increase

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11
Q

Factors to consider when assessing the optimal capital structure

(review)

A

The firm’s overall corporate strategy

The firm’s operating risks and earnings volatility

Immediate and expected long-term financing needs

Relative costs of debt and equity at the time funds must be raised

Risk tolerance of the board of directors and senior management

Potential impact on the firm’s credit rating

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12
Q

Can equity holders force a company into bankruptcy?

A

No

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13
Q

Instead of narrowing in on one specific equity/debt mix from the trade-off theory, most firms will do what?

A

They will develop a band of optimal mixes where the WACC does not vary too much

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14
Q

A firm on the lower end of the debt range for a WACC mix would be known as what? A firm on the higher end of the debt range for a WACC mix would be known as what?

(as it relates to debt capacity)

A

Significant debt capacity

Little debt capacity

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15
Q

If you raise too much financing through debt, what risk do you pose to the firm?

A

Lowering the firm’s overall value

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16
Q

Rather than being a conscious decision, the WACC that a firm achieves may be heavily influenced by what?

(general idea)

A

Historical profits
Investments
Markets

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17
Q

Factors Influencing Target Capital Structure
* Business and Financial Risk
* Asset Structure
* Shareholder Control and Dilution
* Profitability
* Market Conditions
* Lender and Rating Agency Considerations
* Minimum Capital Requirements

A

Business and Financial Risk – lower levels of business risk or financial risk are able to carry higher levels of debt

Asset Structure – ability to use asset as collateral for loans can allow for higher levels of indebtedness; degree of operating leverage may also influence management ability to assign assets as collateral

Shareholder control and dilution – must be mindful of current level of control and distribution of earnings

Profitability – profitable firms will have increased access to debt

Market conditions – current and expected conditions in the macroeconomic environment

Lender and rating agency considerations – covenants may restrict from the lender side and ratings agencies usually provide guidance around ratios that should be maintained for higher credit ratings

Minimum capital requirements – various countries or regional governments may have specific capital requirements for certain industries

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18
Q

Business Risk

(how is this measured?)

A

Stability and predictability of overall revenue stream

Degree of operating leverage

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19
Q

Financial Risk

(and measurement)

A

Variability in net income and cash flows

Degree of financial leverage

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20
Q

Thinly Capitalized Subsidiaries

A

Subsidiaries that have high levels of debt and ultimately generate favorable tax deductions in that jurisdiction

Increasing desire to limit this type of activity

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21
Q

The use of dividends to transfer profits from global subsidiaries is often restricted by whom?

A

The local governments

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22
Q

Intercompany Dividends Key Points

(review)

A

Dividends must comply with local governmental regulations

Significant tax planning may be required

Subject to FX gain/loss and withholding taxes

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23
Q

Management Fees

(how are these cleared with the local governments?)

A

May charge subsidiaries licensing fees, royalties, and/or management fees

Fees are usually negotiated with the government in advance

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24
Q

Transfer Pricing

(and how should it be priced?)

A

Price that subsidiaries of a large corporation charge one another for their economic activity between them

Must be done at arm’s length

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25
What happens if companies do not clearly determine and document value creation by group entity for tax purposes when it comes to transfer pricing?
BEPS framework permits local tax authorities to reassign income to members in different taxing jurisdictions
26
Are withholding taxes usually assessed on cross-border interest payments for intercompany loans?
Yes
27
Are withholding taxes usually assessed on cross-border principal payments for intercompany loans?
No
28
Deemed Dividend
Payments on loans, sales of stock, or other transactions may be interpreted by an attempt by the company to avoid paying taxes on dividends
29
What are some best practices to ensure intercompany transactions are not subject to additional scrutiny and correction by taxing jurisdictions?
Make sure rationale is clearly documented Make sure agreements are clearly documented Make sure payments occur consistently are timely
30
How do NFPs raise capital equity other than through retained earnings?
Government grants and charitable contributions
31
How do NFPs usually extend their financing?
Issue debt
32
What unique advantages for debt issuances are available to NFPs?
Tax-exempt financing in the US Usually an overall lower cost when compared to an equivalent for-profit operation
33
Are NFPs primarily concerned with minimizing their WACC? What is their primary concern?
No They are primarily focused on a manageable level of debt and looking for a sustainable interest coverage ratio
34
If a firm focuses solely on minimizing the weighted average cost of capital, what limitation can it face?
Limited financial flexibility
35
What is one business condition that helps firms achieve higher debt levels compared to those that do not have this factor?
High-resale value liquid assets Assets that can be used for collateral
36
The minimum necessary price for an arm’s length transaction would be what?
The market value of the goods/services (what they would be sold to an unrelated third party for)
37
Why is it not correct to assume a limitation for a company working to minimize the WACC would be to have a very high debt ratio and low coverage ratio?
Higher levels of debt increase risk, so this would not result in an overall minimized WACC (think of the chart)
38
What is one of the primary determinants of long-term success for a given firm as it relates to the capital structure?
Their ability to raise capital at a reasonable price
39
Pros and Cons of Raising Capital in Public Markets
**Pros** * Potential to raise large amounts of debt and equity at prevailing rates **Cons** * Significant cost involved in reporting, disclosure, and rating agency requirements * Dealing with multiple external parties that need to be satisfied, each with their own perspectives
40
How can private companies go public without an IPO?
Be acquired by a Special Purpose Acquisition Company (SPAC)
41
Is an IPO only for equity securities?
No, there can be debt-IPOs as well IPO refers to first issuance of securities
42
Advantages of Going Public * Diversification for owners * Increased liquidity * Increase transparency * Improved ability to spin off divisions
**Diversification for owners** – owners of closely held firms can use proceeds of sales to increase their personal diversification and raise capital **Increased liquidity** – stock of closely held firms is very illiquid with multiple restrictions on how it can be sold **Increase transparency** – compliance with reporting requirements should enhance and increase a firm’s ability to maintain capital, otherwise it is an unnecessary cost **Improved ability to spin off divisions** – can spin off divisions as needed where it may be more advantageous
43
Disadvantages of Going Public * Regulatory disclosure * Managerial flexibility * Control * Exposure to market conditions
**Regulatory disclosure** – level of disclosure can be costly and requires revealing information that companies may not want to be public (e.g. compensation) **Managerial flexibility** – owner have greater flexibility and don’t have to worry about activist shareholders **Control** – surrender control and minority interests may have larger influence, especially where cumulative voting is allowed **Exposure to market conditions** – value of shares is sensitive to capital market conditions, which increases the likelihood of a takeover or acquisition
44
Cumulative Voting
Allows for a greater likelihood that minority interest will be represented on the board Number of shares is multiplied by the number of board members being elected
45
What are automated quotation systems and how are they impacting stock issuances?
Examples include Nasdaq or Jasdaq Started out as computer-based OTC trading system that are now officially recognized exchanges
46
Advantages of Listing Stock on an Exchange
Increase marketability Increased sales due to increased exposure Firm value may be increased due to additional disclosure being perceived as a reduction in risk
47
Disadvantages of Listing Stock on an Exchange
Exchanges will have rules in addition to what regulators may require
48
Is delisting of stock a voluntary or involuntary action?
It can be both as some firms may choose to get delisted and avoid additional compliance
49
Can delisted stock from an exchange still be traded OTC?
Yes
50
Why would a firm’s stock be involuntary delisted?
It fell out of compliance and didn’t make remedies during the designated time allotted
51
Dual- or Multi-Class Stock
Provide different rights to different shareholders
52
Dual-Class Stock System
Usually Class A and Class B Class A is preferred stock with limited voting rights but preference for dividends and will be sold to the public Class B is common stock with voting rights, allowing owners and executives to have greater voting power
53
What are the two strategies for valuing stock at IPO?
**Absolute Valuation** – discounting forecasted cash flow to PV and calculating economic value **Relative Valuation** – identifying similar listed companies and computing value using those companies’ price to earnings ratios or other market valuations
54
At The Market (ATM) Stock Programs
Alternative to underwriting fixed number of stocks at fixed price Issuance of up to a specific amount of equity over time that is sold into the existing secondary market at the current market price on an as-needed basis Provides greater financial flexibility
55
What is the difference in filing requirements for an ATM stock program?
The firm must file a shelf registration to cover the potential issuance of stock
56
ATM Stock Programs are also known as what?
Dribble plans
57
As part of an ATM stock program, how many broker-dealers are required?
Just one specific broker-dealer will be authorized
58
What restrictions are there on private stock issuances?
They cannot be sold on a public exchange nor marked for general sale to retail investors
59
Section 4(a)(2) of the Securities Act of 1933 provides what for issuers not involving any public offerings when it comes to debt securities?
Exemption from the requirement to register privately placed securities with the SEC
60
SEC Rule 144A permits what?
The resale of privately placed debt to qualified institutional investors
61
Benefits to Private Debt Placement | (review)
Less restrictive covenants Ability to offer relatively smaller issue sizes Reduced time to issuance Fewer reporting and disclosure requirements Lower costs Control over who purchases the debt initially Greater flexibility of terms and maturities
62
Disadvantages of Private Debt Placement | (both the investor and investee perspectives / review)
Difficulty and cost finding investors Limited information about the company from the investor’s perspective Investor’s desire for more equity in exchange for assuming greater risk and lower liquidity
63
Three Key Areas for Managing Long-Term Capital
Payments associated with the security need to be administered efficiently Companies have to decide how to reward shareholders (dividends or stock repurchases) Finance a growth strategy involving acquisitions and mergers
64
Relationships that Treasury may manage as part of investor management | (review)
Trustees for debt issuances Disbursing agents Bank credit relationships Investor relations
65
Shareholder Rights and Privileges * Control * Cumulative Voting * Proxy * Staggered Election of Directors * Preemptive Right
**Control** – right to elect directors **Cumulative Voting** – allows for as many votes per share owned as there are open positions on the board **Proxy** – right to vote at the annual meeting can be assigned to another individual or proxy advisory firm; may be assigned to a company executive **Staggered Election of Directors** – used to make it difficult to take over the board or that continuity is helpful **Preemptive Right** – existing shareholders will have the first right to purchase shares of any new stock issue on a pro rata basis
66
Can shareholders assign their preemptive rights to third parties?
Yes
67
Institutional Shareholder Services (ISS)
Example of a proxy advisory firm
68
Proxy Fight
Shareholder groups aggressively solicit the proxies of other shareholders
69
Dividend Catering
A dividend policy determining the type of investor that is likely to be interested in being a shareholder given the trade off between capital appreciation and higher dividends
70
Three Key Components of an Optimal Dividend Policy
Maximizes shareholder value Allows for the sufficient retention of funds for future asset expansion Provides information to investors about the future earnings of the firm (dividend signaling)
71
Dividend Signaling
Providing investors information about the future earnings of the firm based on actions taken surrounding dividends
72
Dividend Payment Dates | (in order)
**Declaration Date** – date the board announces or declares the dividend **Record Date** – shareholder-of-record date when the firm looks at its records to determine shareholders eligible to receive the dividend **Ex-dividend Date** – the first date on which the stock is sold without entitlement to the upcoming dividend; usually one business day prior to the record date **Payment Date** – date shareholders are paid, usually using a transfer agent
73
In theory, what should happen to the stock price on the ex-dividend date?
It should decrease by the amount of the dividend
74
Dividend Reinvestment Plans (DRIPs)
Existing shareholders can purchase additional shares directly from the firm on a when-desired basis with little to no commission Overall favorable pricing and beneficial for smaller shareholders
75
Downsides to DRIPs
Increases the number of small shareholders, so there are additional records and needs to potentially cater to
76
Are stock splits dividends? Would they be considered part of the dividend policy?
No, but they are usually considered as part of the policy
77
Cash Dividends
Most common form of dividend payment usually paid on a quarterly basis
78
Stock Dividends
Shareholders are paid dividends with additional shares of stock Stock’s per-share price is reduced due to additional share in circulation, but there is no real impact on shareholder wealth since the added shares do not alter the firm’s overall value Dilution in earnings caused by the stock dividend will cause a fall in share price, but it will quickly be corrected so that the overall value is not impacted
79
Why might a firm consider a stock dividend even if it has previously paid out cash dividends?
It’s a way to appease shareholders who expect a dividend but the company needs to conserve cash for expensive investment alternatives
80
What other types of companies would a stock dividend be useful for?
High-growth startups that need to retain cash
81
Special Dividend
Meant to be a one-time payment rather than an ongoing dividend increase
82
Liquidating Dividends
Paid out of capital rather than earnings May be useful when a division is going out of business or a leveraged buyout
83
Stock Splits
Existing shares are split into one or more shares Idea is that there is a desirable price range for a stock’s price
84
Reverse Stock Split
Consolidating shares into fewer outstanding shares to increase the share price
85
Stock Repurchases
Purchasing stocks back in the open market to drive shareholder value potentially in lieu of dividends
86
What provides more flexibility than paying a dividend while also increasing shareholder value?
Stock repurchase program
87
How are dividends normally treated for tax purposes?
They are usually taxable income
88
What types of restrictions may exist for a firm contemplating paying out dividends?
Borrowing arrangements / covenants Financial authorities Government authorities
89
Divestiture
Sale or closure of part of a company, often a subsidiary
90
Merger of Equals
Two firms of equivalent size combine into one company to move forward Not very common in practice
91
Why do firms like to promote the idea that something is a merger of equals even when it is more of an acquisition?
It won’t carry the negative connotations of being bought out and will make it feel more appealing
92
Friendly Acquisition
Bidder will inform the other firm’s board of directors of its intention to acquire All parties will cooperate together
93
Hostile Takeover
Target is expected to fight the acquisition
94
Tender Offers for Hostile Takeovers are usually more or less expensive than negotiated M&As?
More expensive due to resistance and the fact that the target is now in play and may attract other buyers
95
Two Options for Hostile Takeovers
**Tender Offer** – offer directly to the shareholders **Proxy Fight** – secure enough proxies to install favorable board of directors
96
Creeping Tender Offer
Slowly purchasing sufficient stock on the open market to enable a chance in management
97
Leveraged Buyout (LBO)
Acquisition is financed using a significant proportion of debt
98
LBO Structure * Primary Form of Collateral * Debt is carried on which firm's books * Debt servicing is for which entity
Primary form of collateral – acquired firm’s assets, though in rare cases it may be the acquirer Debt is carried on which firm’s books – acquired firm Debt servicing is for which entity – acquired firm
99
What is the other purpose an LBO can serve beyond a typical acquisition?
It can be used to take a firm private by raising debt financing to buy back all shares at a premium
100
Two Key Differences for LBOs compared to Ordinary Acquisitions
Large portion of the purchase price is debt-financed that is usually non-investment grade debt LBO goes private and shares are no longer traded on the open market
101
Is the debt that is issued for an LBO transaction usually investment grade?
No, it is usually considered junk due to the high leverage involved
102
Management Buyout
Group of partnership investors in a LBO for taking a firm private are led by the company’s management
103
How do LBO investors hope to capture value in an LBO?
Selling off the acquired firm’s assets in pieces or trying to keep those that are profitable Short-term duration of ~5 years
104
Typical Forms of Divestitures | (review)
Sale of divested entities to one or more third-parties Establishment of a new firm Closure of part of the business
105
Common Structures for Financing M&A Transactions | (review)
All-cash transactions Stock transactions, financed through the exchange of stock Mixed stock/cash transactions Leveraged cash transactions, financed through debt issue Leveraged buyouts, with the majority of equity replaced by debt Debt transactions, financed through debt offered to the acquired company’s shareholders Mixed cash/debt transactions Preferred stock transactions
106
Cash Sources for M&A Transactions | (review)
Cash from acquiring firm Excess cash from the acquired firm Cash from the sale of some of the acquired firm’s assets Issuance of investment-grade bonds Issuance of non-investment-grade bonds that have an amortization schedule supported by a forecast of operating cash flows
107
Focus Areas for Treasury following Acquisition | (review)
Bank Relationships – bank rationalization Cash Management Activity – standard processes, workflows, and controls Technology Use – determining the best solutions to use Short- and Long-Term Investments – portfolios may need to be adjusted The Group Debt Portfolio – consider restructuring borrowings The Capital Structure – appropriate target capital structure
108
What is the real difference in terms of differentiating between a friendly and hostile takeover?
How the purchase is communicated to and received by the target firm’s board of directors, employees and shareholders
109
Perpetual Bond
A bond without a maturity date where interest payments are made regularly but it is never required to repay the principal Hybrid security
110
Three Primary Reasons to seek funding other than Debt and Equity * Risk Management * Cash Flow Management * Balance Sheet Management
Risk management – establishing a separately capitalized stand-alone entity, like a joint-venture or special-purpose vehicle Cash flow management – short-term financing techniques Balance sheet management – more closely aligning the financing with the assets being financed; more limitations on off-balance sheet financing
111
Bankruptcy Remote
Concept tied to special-purpose vehicle wherein bankruptcy of that specific entity will not impact the other entities within the group
112
An alternative to borrowings for capital asset financing would be what?
Leasing
113
What is a key reason for leasing that will benefit both the lessor and the lessee?
Tax benefits
114
What are some advantages besides tax benefits that leasing can offer?
It can allow companies with poorer credit quality ratings to obtain financing Leases will likely offer less restrictive terms than typical loan covenants
115
If a firm is operating in an industry where capital assets may have a high potential for technological obsolescence, does leasing make sense?
Yes
116
Primary Differences among Lease Types | (review)
Length of lease period Party responsible for asset maintenance and upkeep Residual value of the asset Relevant tax treatment (more significant for NFPs) Party retaining the asset at the end of the lease and the lease terms
117
What is the criteria for recording an operating lease on the balance sheet?
Greater than one year Operating leases under a year do not have to be recorded
118
IFRS 16 Two Exemptions for Recording Finance Lease Payments as Expenses
Under one year term Lease of a low-value asset
119
ASC 842 Criteria for Finance Lease (any one will qualify) * Length of Lease * Transfer of Ownership * Bargain Purchase Option * PV of Discounted Cash Payments * Leased Asset Specialization
**Length of Lease** – major part of the estimated useful life of the asset **Transfer of Ownership** – occurs for finance leases **Bargain Purchase Option** – allows lessee to purchase the asset at a bargain price such that an expectation is created that it will be exercised due to favorable pricing **PV of Discounted Cash Payments** – substantially all of the asset’s FMV **Leased Asset Specialization** – asset is highly specialized and is likely to have no alternative use for the lessor at the end of the lease
120
Residual Value is associated with which type of lease, operating or finance lease?
Finance leases
121
Sales and Leaseback Arrangements
Helpful to provide more flexibility for the original owner by allowing them to get cash upfront
122
Are Sales and Leaseback Arrangements considered sales under ASC 842?
No
123
If an asset has a higher residual value, will payments on the lease generally be higher or lower?
Lower
124
What may occur if there is a difference between the actual residual value and the expected residual value of an asset in a lease?
Lessee may need to reimburse the lessor if it is lower than originally expected
125
Funding Leases or Hire-Purchase Agreements
Other global terms for finance leases
126
Does IFRS distinguish between operating and finance leases?
No
127
What is the tax treatment by the US IRS for operating leases?
They are fully deductible
128
What is the tax treatment by the US IRS for finance leases?
Interest portion is deductible Depreciation is deductible
129
What is the primary reason the IRS places restrictions on lease terms?
To avoid lessees setting up a lease arrangement that allows for a more rapid write-off of an asset than tax depreciation rules
130
Which discount rate would be most appropriate to use for lease versus borrow and buy decisions?
The cost of the debt would be appropriate as it represents the opportunity cost
131
Unlike normal PV calculations, payments for leases occur at the beginning and are known as?
Annuity due
132
A subsidiary lending funds to the parent company could potentially be classified as what?
A deemed dividend Cash flows moving from the subsidiary to the parent could be classified as dividends being paid to the parent company to consolidate capital
133
Do most companies attempt to meet the optimal capital structure when raising new capital?
Not necessarily, as many companies must accommodate other factors to arrive at a target capital structure
134
Are road shows just for an IPO? What umbrella do they generally fall under?
No, they can also be used for subsequent securities issuances These would fall under investor relations, which Treasury may help support and assist with

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