Los 25.c Flashcards
(16 cards)
What is the static tradeoff theory of capital structure?
The static tradeoff theory suggests that firms aim to balance the tax shield benefits from debt financing with the costs of financial distress. There is an optimal capital structure where the tax shield from debt maximizes firm value, but further debt increases financial distress costs, which can reduce firm value.
How is the value of a levered firm represented in the static tradeoff theory?
Value of Levered Firms = Value Unlivered firm + (tax * debt) - PV (costs of financial distresS)
What does the Static Tradeoff Theory: Cost of Capital vs. Capital Structure graph illustrate?
It shows the relationship between the cost of capital and the capital structure, indicating that firm value initially increases as debt financing rises. However, at some point, the costs of financial distress outweigh the tax benefits of debt, leading to a decrease in firm value.
What does the Static Tradeoff Theory: Firm Value vs. Capital Structure graph show?
It illustrates that the firm’s value increases with debt financing up to a certain point, after which it declines as the costs of financial distress outweigh the benefits from the tax shield of debt.
How does the static tradeoff theory relate to MM’s propositions?
MM’s propositions without taxes or costs of financial distress state that capital structure is irrelevant, meaning WACC and firm value are unaffected by debt. With taxes but no distress costs, MM suggests that firm value is maximized at 100% debt. The static tradeoff theory refines this by factoring in the costs of financial distress, indicating that firm value and WACC will be maximized at an optimal level of debt, not necessarily 100%.
What is a target capital structure?
A target capital structure is the mix of debt, equity, and possibly preferred stock that a firm seeks to maintain over time to maximize its value. It reflects management’s beliefs and external/internal factors, such as business risk, tax rate, and governance.
How do analysts estimate a firm’s target capital structure?
Analysts can estimate a firm’s target capital structure in several ways:
Using the firm’s current capital structure based on market values.
Incorporating trends in the firm’s capital structure over time.
Using the average capital structure of the firm’s industry.
Why do managers often focus on book values of debt and equity for internal analysis?
Short-termflucutations in market debt and equity do not affect a companies appropriate level of debt
Credit rating agencies use book values to assess credit quality.
Book values are more aligned with internal capital deployment strategies, unlike market values, which reflect investor perspective
What causes fluctuations in a firm’s actual capital structure compared to its target?
Market fluctuations, particularly in equity values.
Opportunities to exploit specific financing sources, such as issuing equity when stock prices rise.
The necessity to raise capital in minimum amounts, making precise adherence to target weights difficult.
What are costs of asymmetric information?
Costs of asymmetric information arise because managers typically have more information about the firm’s prospects than owners or creditors. Firms with less transparency or complex products tend to face higher asymmetric information costs, which result in higher required returns on both debt and equity.
How do investors react to asymmetric information in firms?
Investors recognize the potential for asymmetric information, and they interpret management’s financing choices as signals of the firm’s prospects. For instance:
Taking on debt signals management’s confidence in future cash flows.
Issuing equity may signal that management believes the stock is overvalued.
How does the cost of asymmetric information change with the equity proportion in the capital structure?
As the proportion of equity increases, the cost of asymmetric information rises because equity issuance is often perceived as a negative signal by investors, indicating that management believes the firm’s stock is overvalued.
What are agency costs of equity?
Agency costs of equity arise from conflicts of interest between managers (who may not have a significant stake in the company) and shareholders. These costs include:
Monitoring costs: Costs associated with overseeing management.
Bonding costs: Costs to ensure managers act in the shareholders’ best interest.
Residual losses: Losses that occur even with adequate monitoring and bonding.
What is the free cash flow hypothesis?
The free cash flow hypothesis suggests that using debt financing reduces agency costs by forcing managers to be disciplined in their spending, as debt obligations limit the availability of free cash flow for non-value-creating activities.
What is pecking order theory?
Pecking order theory states that firms prefer financing options in the following order:
Internally generated capital (retained earnings).
Debt financing.
External equity issuance (which is seen as the least desirable due to negative signals it may send to the market).
How does pecking order theory explain capital structure decisions?
According to pecking order theory, capital structure is a by-product of individual financing decisions based on which source of capital is least likely to send negative signals to the market. Firms prefer to use internal funds first, then debt, and only issue equity as a last resort.
