Important theory

Question 1

Name 3 interest rate theories and describe them.

Answer 1

Pure expectations - term structures reflect expectations of future short term interest rates and inflation. (maturity is indifferent)
Liquidity - Long term yields include a premium for additional risk. Will be upward sloping on average
Market segmentation - Bonds with different maturities are not substitutes for each other, thus have different supply&demand.

Question 2

Describe the pecking order theory.

Answer 2

Cost of financing increases with asymmetric information.
When choosing how to raise finance: Internal financing -> debt -> new equity.
Profitable firms borrow less - enough earnings to fund investment.

Question 3

Describe the trade-off theory.

Answer 3

States the optimal capital structure is a trade-off between tax shields and costs of distress.
Eventually, the costs of financial distress will overpower the tax shields.

Question 4

Name the positive effects of more debt.

Answer 4

Maximize the effect of leverage.

Tax shields

Question 5

Name the negative effect of more debt.

Answer 5

Repayment
High rates
Lower credit rating (more liabilities = more risk for creditor)
Have to generate enough money to pay off the debt.

Question 6

Describe the equity holder - debt holder conflict.

Answer 6

It comes with financial distress when one can win and the other can lose.
Cashing out: wealth is transferred from D to E
Playing for time: D holders want leftovers now, but E holders want to wait and hope for value to bounce back.
Bait & switch: Issue limited debt -> issue same priority debt -> price drops -> start operations. (Transfer wealth from old to new bondholders)

Question 7

Name the bond risks

Answer 7

Credit risk, Inflation, Interest rate, liquidity, exch rate, call risk, reinvestment risk, default risk.