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finance 2 > Debt > Flashcards

Debt Flashcards

1
Q

What is capital structure?

A

Capital structure is the proportion of debt, equity and other securities that a firm uses to finance its operations

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2
Q

What is debt?

A

The cash flows that are capped to the promised amounts

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3
Q

What are debtholders entitled to?

A

interest payments and the principal at maturity

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4
Q

Who has seniority on the firm’s cash flows?

A

debtholders

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5
Q

True or false: debtholders have voting rights.

A

False

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6
Q

What is equity?

A

The rights to the cash flows after debtholders are paid

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7
Q

True or false: equityholders have voting rights.

A

True

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8
Q

Who has ownership over the firm: debt or equityholders?

A

equityholders

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9
Q

Who has residual claimants of the firm’s cash flows?

A

equityholders

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10
Q

Who has limited liability?

A

equityholders, since shareholders aren’t personally liable if the firm goes bankrupt

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11
Q

What other examples besides debt and equity can be part a firm’s capital structure?

A

Warrants, convertible debt, leasing, hybrid securities, etc.

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12
Q

What does it mean when equity is unlevered?

A

There’s no debt D/E=0

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13
Q

What is the main conclusion of M&M?

A

Under perfect capital market conditions, the total value of a firm doesn’t depend on its capital structure.

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14
Q

Why is is that under perfect capital market conditions, the total value of a firm doesn’t depend on its capital structure?

A

Because total cash flows to the investor of the firm are equal to the cash flows that the project will generate, and therefore have the same present value.

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15
Q

What are the assumptions for M&M Proposition 1?

A
  1. investment policy is held constant
  2. no transaction costs
  3. capital markets are efficient
  4. managers maximise shareholder’s wealth
  5. no taxes
  6. no bankruptcy costs
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16
Q

What is the M&M Proposition 1?

A

Under perfect market condition a firm’s market value is independent of its capital structure.

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17
Q

What does “the size of the pie” depend on?

A
  1. operating policy by firm
  2. working capital policy
  3. investment policy
  4. business risk (and corresponding risk premium)
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18
Q

What can’t exist in perfect capital market?

A

Arbitrage opportunities

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19
Q

What is arbitrage?

A

Arbitrage consists of taking advantage of mispricing in the market and usually involves the simultaneous purchase and sale of securities that are supposed to have the same price to make a riskless profit. It has to have non-negative cash flows at all instances and at the very minimum, a non-zero probability of getting a positive cash-flow in at leat one moment in time.

20
Q

What will result from the actions of arbitrageurs?

A

Their actions result in the price of the cheapest one to rise and the most expensive to fall, making the arbitrage opportunity to disappear.

21
Q

What does leverage cause to equityholders?

A

It increases their risk and therefore the return they ask for increases to compensate for the extra risk.

22
Q

Dow we need risky debt for leverage to increase the risk on equity?

A

No

23
Q

Following M&M, what is the WACC equal to?

A

return on assets

24
Q

Following M&M, does the WACC depend on the mix of securities the firm has outstanding?

A

No, WACC only depends on its assets and operating activities.

25
Q

What does the M&M Proposition 2 tell us?

A

The return on equity is equal to the return on assets plus a premium to compensate for the financial risk caused by leverage.

26
Q

What happens when we apply the CAPM on Proposition 2?

A

We obtain an equivalent relation for betas.

27
Q

True or false: the higher the leverage, the risker the equity.

A

True

28
Q

Is holding excess cash part of the financing decision?

A

Yes.

29
Q

What is excessive cash?

A

Excessive cash is cash and short-term investments that aren’t used in the company’s operations.

30
Q

True or false: M&M Proposition 2 tells us that the systematic risk of equity increases with leverage.

A

True

31
Q

Why does systematic risk of equity increases with leverage?

A
  1. debt carries less systematic risk than equity
  2. fewer shareholders are carrying the same asset risk that would be shared by more equityholders if the firm was all-equity financed
32
Q

What is riskless debt?

A

cash flows are always higher than the promised payment on debt in all realisations of the future

33
Q

What is risky debt?

A

there is at least one realisation of the future where cash flows are lower than the promised payment on debt

34
Q

When we have risky debt, does the value of the assets and the opportunity cost of capital change?

A

Not under perfect market conditions

35
Q

If debt is risky, does the equity cost of capital increase?

A

Yes

36
Q

True or false: the WACC changes for alternative capital structures

A

False

37
Q

In perfect capital markets, is WACC equal to the asset cost of capital?

A

Yes

38
Q

What drives the riskiness of securites?

A

The riskiness of assets

39
Q

Does the riskiness of securities drive the riskiness of assets?

A

No, it’s the other way around.

40
Q

If the firm is all-equity financed is the beta from equity equal to the beta from assets?

A

Yes

41
Q

When does rA change?

A

taxes

42
Q

How do you calculate wealth?

A

wealth = P + DPS

43
Q

If debt is risk free what is the value of debt’s beta?

A

0

44
Q

Does P change when you repurchase stock?

A

no

45
Q
A

finance 2 (6 decks)

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