Session 6

Question 1

What are the key assumptions of a perfect capital market?

Answer 1

A perfect capital market is one where financial assets are traded without any frictions, allowing for efficient allocation of resources. The key assumptions include:

1. No Taxes – Financial decisions are not influenced by tax considerations.
2. No Bankruptcy or Financial Distress Costs – No costs related to financial distress or insolvency.
3. No Information Asymmetry – All investors have access to the same information, eliminating any advantage from privileged knowledge.
4. No Transaction Costs – Buying and selling securities do not incur fees or commissions, ensuring frictionless trading.
5. Individuals and Corporations Borrow at the Same Rate – No preferential treatment by lenders; borrowing costs are the same.
6. Other Assumptions – Rational investors, no arbitrage opportunities, and complete markets where all assets can be traded.

In reality, perfect market conditions do not exist due to taxes, transaction costs, information asymmetry, and financial distress costs.

Question 2

What is financial leverage?

Answer 2

Financial leverage refers to the use of debt financing to increase potential returns for equity holders. Instead of relying only on equity financing, a company borrows money (debt) to fund operations or investments.

Question 3

What happens to a company’s capital structure when it takes on debt to buy back equity?

Answer 3

The company’s capital structure shifts from being unlevered (only equity) to levered (a mix of debt and equity). This increases financial leverage and reduces the number of shares outstanding.

Question 4

How does leverage impact Earnings Per Share (EPS)?

Answer 4

Effects on Earnings Per Share (EPS):

• At low earnings levels: EPS is lower due to fixed interest costs (disadvantage).
• Break-even point: There is an earnings level where leverage neither helps nor hurts.
• At high earnings levels: EPS grows at a faster rate than in an unlevered firm (advantage).

Benefits: Higher EPS in profitable periods, lower cost of capital.
Risks: Fixed interest payments increase financial risk, especially in downturns.

Leverage is beneficial when earnings are stable and growing but risky in uncertain environments.

Question 5

What is MM Proposition I (Capital Structure Irrelevance), and what are its key assumptions?

Answer 5

MM Proposition I states that in a perfect market, the total value of a firm is independent of its capital structure (whether financed by equity, debt, or a mix).

Key Ideas:

• A firm’s cash flows remain the same regardless of financing.
• Follows the Law of One Price – equivalent assets should have the same value in competitive markets.

Key Assumptions:

• Investors and firms can trade securities at market prices.
• Individuals can borrow at the same rate as firms.
• No taxes, transaction costs, or financial distress costs.
• Financing decisions do not affect the firm’s cash flows.

Conclusion: Under perfect conditions, capital structure does not impact firm value.

Question 6

What is MM Proposition II, and how does it explain the effect of leverage on risk and return?

Answer 6

MM Proposition II states that as a firm takes on more debt, the expected return on equity (cost of equity) increases due to higher financial risk borne by equity holders.

Key Insight:

• While debt is cheaper than equity, the increased risk for shareholders leads to a higher cost of equity (RE)
• In a no-tax world, the firm’s Weighted Average Cost of Capital (WACC) remains constant because the lower cost of debt is offset by the higher cost of equity.

More debt increases equity risk but does not reduce WACC under perfect market conditions.

Question 7

How is the cost of capital calculated for an all-equity firm (unlevered firm)?

Answer 7

For an all-equity firm (no debt in capital structure), the required return is denoted as Ru (also written as Ra)

Interpretation:

• Represents the required return for a company financed entirely by equity.
• Since there is no leverage, there is no financial risk from debt, meaning all risk is business risk.

Question 8

What is the formula for MM Proposition II, and what does it imply?

Answer 8

• Ru represents the firm’s business risk, which does not change with leverage.
• The term D/E(Ru - Rd) represents the additional risk equity holders bear due to leverage.
• Since debt is cheaper than equity, adding debt raises the cost of equity, keeping the overall cost of capital unchanged (assuming no taxes).

As a firm takes on more debt, equity holders require higher returns due to increased financial risk.

Question 9

How does MM Proposition II explain the relationship between leverage and equity risk using beta formulation?

Answer 9

The firm’s asset beta ßA represents the overall risk of the firm and is a weighted average of debt and equity betas:

Implications: Equity beta ße increases as leverage increases.

Shareholders bear more risk when firms take on more debt because:

• Debt holders get paid first, making equity holders exposed to more volatility.
• If the firm faces financial distress, equity becomes even riskier.

Conclusion: Higher leverage increases risk for equity holders, leading to a higher required return on equity, confirming MM Proposition II

Question 10

What are the main insights from MM Proposition II?

Answer 10

Leverage Increases Equity Cost:

• Shareholders bear more risk when firms take on more debt.
• Therefore, the cost of equity Re increases with leverage.

WACC Remains Constant (No Taxes):

• Even though equity becomes more expensive, the cheaper cost of debt offsets it.
• This results in an unchanged WACC in a no-tax environment.

Debt is Initially Cheap but Riskier at High Levels:

• At low levels of debt, Rd (cost of debt) is stable.
• At very high leverage, Rd increases due to higher bankruptcy risk.

Conclusion: More debt raises equity risk, but WACC remains constant unless bankruptcy risk increases significantly.

Question 11

What is MM Debt Policy Irrelevance, and when does capital structure matter?

Answer 11

MM Debt Policy Irrelevance (MM Proposition I) states that, in a perfect world, a firm’s capital structure (mix of debt and equity) does not affect its total value.

MM Assumptions (Perfect Market Conditions):

• No taxes
• No bankruptcy or financial distress costs
• No information asymmetries
• No transaction costs

When Does Capital Structure Matter?

• If any of the perfect market assumptions do not hold (e.g., taxes, bankruptcy costs, or information asymmetries exist), capital structure can impact firm value.

What MM Proposition does NOT Say:

• It does not mean all stakeholders (e.g., bondholders vs. shareholders) are indifferent to capital structure.
• Value can shift between bondholders and shareholders, but total firm value remains unchanged in a perfect world.

Conclusion: Essentially, MM Proposition I is a theoretical benchmark, but in reality, capital structure can be important due to market imperfections.

Question 12

Why do firms use debt financing in relation to corporate taxes?

Answer 12

Firms use debt financing because interest payments on debt are tax-deductible, reducing the overall corporate tax burden. This creates a tax shield, where firms save money by deducting interest expenses from taxable income.

Question 13

What is the formula for tax savings (tax shield) from interest payments?

Answer 13

The tax savings (tax shield) per period from interest payments is:

This means the firm reduces its taxable income by tc times its interest expense.

Question 14

What is the present value (PV) of the tax shield, and what does it imply?

Answer 14

The present value (PV) of the tax shield, assuming perpetual debt, is:

Implication:

• For every unit of debt D, the firm gains additional value equal to tcD due to tax savings.
• This shows that higher debt increases firm value when taxes exist, contradicting MM Proposition I (which assumes no taxes).

Question 15

How does debt affect firm value according to MM Proposition I with corporate taxes?

Answer 15

According to Modigliani-Miller Proposition I with corporate taxes, the value of a firm increases with debt due to the tax shield on interest payments.

Since debt financing reduces taxable income, firms increase in value by the amount of the tax shield, giving them an incentive to use debt.

Question 16

How does MM Proposition II change with corporate taxes, and what is its formula?

Answer 16

With corporate taxes, MM Proposition II states that the expected return on equity Re increases as the firm’s leverage (D/E ratio) increases.

Key Implications:

• More debt → Higher Re (equity holders take on more risk).
• WACC decreases with leverage due to the tax shield on debt.
• Debt interest is tax-deductible, reducing the firm’s taxable income.

Conclusion: Unlike in a no-tax world, debt reduces WACC when taxes exist, making leverage more beneficial.

Question 17

How does the WACC formula account for the tax benefits of debt?

Answer 17

The Weighted Average Cost of Capital (WACC) formula adjusts for the tax benefits of debt as follows:

• Since interest on debt is tax-deductible, the after-tax cost of debt is used: Rd (1-tc)
• WACC is lower in a world with corporate taxes compared to one without, because the government subsidizes debt financing through tax deductions.

Tax benefits make debt cheaper, reducing the firm’s overall cost of capital and incentivizing leverage.

Question 18

What are the limits to the tax benefits of debt, and what is the optimal leverage level?

Answer 18

Limits to the Tax Benefit of Debt
To maximize tax benefits, a firm must have taxable earnings (EBIT); otherwise, the tax shield is lost.

• Interest should not exceed EBIT to avoid a net operating loss and wasted tax shields.
• Excessive debt offers no corporate tax benefit and may increase investors’ personal tax burdens.

Optimal Leverage Level

The ideal leverage occurs when interest equals EBIT, maximizing tax benefits without excessive debt.

However, predicting future EBIT is challenging, posing risks:

• Interest > EBIT → Reduced tax savings.
• Unused tax shields → Lower firm value.

While debt provides tax advantages, firms must balance leverage to maintain tax benefits and minimize financial risk.

Question 19

What are the key concepts of Cost of Equity, Cost of Debt, WACC, and Unlevered Cost of Capital?

Answer 19

Cost of Equity (rE):

• Represents the return required by shareholders.
• Increases with leverage because higher financial risk raises required returns for equity holders.

Cost of Debt (rD):

• The interest rate required by lenders.
• Initially cheaper due to tax benefits (interest deductibility).
• Higher debt → Increased financial distress → Higher borrowing costs.

Weighted Average Cost of Capital (WACC):

• The firm’s overall cost of financing, considering both debt and equity.
• Moderate debt → WACC decreases (due to tax shield).
• Excessive debt → Higher default risk → WACC increases.

Unlevered Cost of Capital (rU or rA):

• The expected return if the firm was entirely financed by equity.
• Used as a benchmark to compare leveraged vs. unleveraged cost of capital.

While debt can lower WACC up to a point, excessive leverage increases risk and borrowing costs.

Question 20

What is the impact of leverage on beta, and why is beta unlevered?

Answer 20

Impact of Leverage on Beta:

• A stock’s equity beta (ße) depends on the asset beta (ßa), which represents business risk, and the amount of debt in the firm’s capital structure.
• More debt → Higher ße (equity becomes riskier for shareholders).
• This aligns with MM Proposition II (with taxes): Higher leverage increases both risk and return on equity.

Why Unlever Beta?

• To compare a firm’s business risk with other firms without financial leverage distortion.
• ßa represents pure business risk, while ße includes additional financial risk from leverage.

Unlevering beta isolates business risk, making firms more comparable across different capital structures.

Question 21

How do you unlever beta in perfect capital markets, and why is it useful?

Answer 21

Why Unlever Beta?

• Removes leverage effects, allowing us to estimate the true business risk of a firm’s operations.
• Makes firms comparable across different capital structures.

Conclusion: Unlevering beta isolates pure business risk, helping investors and analysts assess the company without financial leverage distortions.

Question 22

How does unlevering beta change in the MM world with corporate taxes?

Answer 22

Impact of Corporate Taxes on Beta:

• Debt creates a tax shield, reducing the firm’s effective risk exposure.
• Since interest on debt is tax-deductible, the effective amount of debt is reduced to (1 - tc)D

Key Takeaways:

• Higher D/E → Greater impact of leverage on equity beta.
• Corporate taxes lower the risk of debt because of tax benefits, reducing its impact on firm risk.

Conclusion: In the presence of taxes, the tax shield offsets some of the risk introduced by leverage.

Question 23

What is Hamada’s equation, and how does leverage affect equity beta with and without taxes?

Answer 23

• Leverage increases the risk of equity by amplifying ße
• However, corporate taxes reduce this effect by creating a riskless tax shield, making equity beta increase less rapidly than in a no-tax environment.

Question 24

What is the Pure-Play Method, and how is it used to assess project risk?

Answer 24

The Pure-Play Method estimates a project’s risk using comparable industry data by following these steps:

1. Identify Pure-Play Firms – Find companies in the same industry with similar risk profiles.
2. Unlever Their Betas – Remove the impact of debt to obtain the asset beta (unlevered beta).
3. Relever the Beta for the Project – Adjust the unlevered beta to match the project’s target capital structure.
4. Compute WACC – Use the new beta to determine the cost of equity and WACC.
5. Assess Project Value (NPV Method) – Discount cash flows using WACC to evaluate project viability.

Conclusion: This method ensures a project’s risk is assessed independently of the firm’s existing capital structure, making it useful for investment decisions.

Question 25

Why do firms often use less debt than expected despite tax advantages?

Answer 25

Even though debt financing provides tax advantages (via tax shields), firms often use less debt than expected due to: * Increased bankruptcy risk associated with high leverage. * Uncertainty in future earnings, making debt obligations riskier. * Asymmetric information – firms may avoid high debt to signal financial stability. Conclusion: While debt offers tax benefits, firms recognize the trade-off between tax shields and financial distress risks.

Question 26

How does leverage affect bankruptcy risk in a perfect market?

Answer 26

**Leverage and Bankruptcy Risk:** * Debt financing increases bankruptcy risk, unlike equity financing. * Default occurs if a firm cannot meet its debt obligations, allowing debt holders to claim assets. * Equity holders bear residual risk, meaning they have no guaranteed payouts if the firm defaults. Conclusion: High leverage raises the risk of financial distress, impacting firm value and investor confidence.

Question 27

How does bankruptcy affect capital structure in perfect vs. real-world markets?

Answer 27

**In Perfect Capital Markets (MM Proposition I, No Taxes):** * A firm’s value is independent of its capital structure * Debt financing does not reduce firm value. * Bankruptcy does not destroy value; it only transfers ownership from equity holders to debt holders. * The risk of bankruptcy itself is not a disadvantage, as it does not change total firm value. **In Real-World Markets:** * Bankruptcy has costs that reduce firm value, making capital structure important. * Financial distress costs include: 1. Direct costs (legal fees, liquidation costs). 1. Indirect costs (loss of customers, employee turnover, operational inefficiencies). Conclusion: In reality, high debt increases financial distress costs, making an optimal capital structure important.

Question 28

What are the direct costs of bankruptcy, and how do they impact firm value?

Answer 28

**Direct Costs of Bankruptcy:** * Legal & administrative costs – Hiring lawyers, financial advisors, and bankruptcy experts. * Creditor-related costs – Delays in payments and additional creditor expenses. * Asset valuation loss – Assets may be sold under distress conditions, reducing their value. **Impact on Firm Value:** * Direct costs reduce total firm value available to investors. * Estimated to be 3–4% of the firm's pre-bankruptcy asset value.

Question 29

What are the indirect costs of financial distress, and why are they significant?

Answer 29

**Indirect Costs of Financial Distress:** * Loss of customers & suppliers (fear of non-payment or delivery issues). * Loss of employees (prefer stable employers). * Fire sale of assets (low prices due to urgency). * Delayed decision-making and liquidation. **Why Are They Significant?** * Harder to measure but much larger than direct costs. * Estimated losses range from 10–20% of firm value. * Some value loss is beyond economic distress, e.g., reputation damage, loss of skilled employees.

Question 30

Who ultimately pays for financial distress costs, and how does it affect equity and debt holders?

Answer 30

**Equity Holders:** * If a project fails, equity holders lose their investment. * In bankruptcy, their shares become worthless, so they do not bear bankruptcy costs directly. * However, because debt holders anticipate risk, the cost of financial distress reduces the value available to equity holders. **Debt Holders:** * Provide loans expecting repayment but may not recover the full amount if the firm defaults. * To compensate for this risk, they demand higher interest rates or lower bond prices. * The discount they apply reflects expected bankruptcy costs. **Who Pays for Financial Distress Costs?** * When securities are fairly priced, original shareholders bear the present value of expected bankruptcy and financial distress costs. * This means equity holders ultimately pay for financial distress through lower firm value.

Question 31

What factors determine the present value of financial distress costs?

Answer 31

**1. The Probability of Financial Distress** Higher liabilities relative to assets → Higher risk * More debt increases repayment struggles. * If cash inflows aren’t enough, financial distress is likely. More volatile cash flows & asset values → Higher risk * Unpredictable revenue makes debt repayment harder. * Example: Startups with inconsistent revenue are riskier than stable firms. **2. The Magnitude of Costs After a Firm is in Distress** * High Financial Distress Costs – Tech Firms * Low Financial Distress Costs – Real Estate Firms

Question 32

Why do technology firms have higher financial distress costs than real estate firms?

Answer 32

**Technology Firms – High Distress Costs** * Lose customers and key employees quickly. * Lack tangible assets to sell for debt repayment. * Example: A failing software company may struggle to sell patents or brand reputation. **Real Estate Firms – Low Distress Costs** * Own physical assets (properties) that can be sold. * Can recover by liquidating assets, making debt repayment easier. * Example: A property developer in distress can sell buildings to pay off debt.

Question 33

What is the Tradeoff Theory of capital structure, and how does it determine the optimal debt level?

Answer 33

**Tradeoff Theory:** * Firms balance the benefits of debt (tax shield) against the costs of financial distress. * Debt increases firm value by providing a tax shield * Too much debt increases financial distress costs (legal fees, customer loss, supplier concerns). * Firms “trade off” these effects to determine the optimal debt level. ## Footnote Firms increase debt until tax benefits equal financial distress costs. Beyond this, more debt reduces firm value.

Question 34

Why do some industries use more debt than others according to the Tradeoff Theory?

Answer 34

**Industries with Low Financial Distress Costs → Use More Debt** * Example: Real estate, utilities. * Can handle higher leverage because they have stable cash flows and tangible assets. **Industries with High Financial Distress Costs → Use Less Debt** * Example: Technology, biotech. * Avoid high leverage because they have volatile earnings and fewer tangible assets. Conclusion: Industries with low financial distress risk benefit more from debt, while those with high distress costs prefer less leverage.

Question 35

What are the agency costs of leverage, and how do they impact firm value?

Answer 35

**Agency Costs of Leverage:** Debt creates agency conflicts, where managers prioritize shareholder gains, potentially increasing firm risk and reducing overall value. * Arise from conflicts of interest between a firm’s stakeholders. * Managers typically aim to maximize equity value, benefiting shareholders. * When a firm has high leverage, managers may take actions that: 1. Benefit shareholders but harm creditors. 1. Lower total firm value due to inefficient or risky decisions.

Question 36

What is over-investment (excessive risk-taking), and how does it relate to asset substitution?

Answer 36

**Over-Investment (Excessive Risk-Taking):** * Happens when equity holders benefit at the expense of debt holders by taking on risky projects. * Occurs when a firm is in financial distress and equity holders have nothing to lose. * They prefer risky strategies that may increase their value, even if the project lowers overall firm value. **Asset Substitution Problem:** * Equity holders shift to riskier investments at debt holders’ expense. * Debt holders anticipate this behavior and respond by: * Charging higher interest rates. * Reducing loan amounts to firms. Conclusion: Over-investment occurs when equity holders take risks that hurt debt holders, leading to higher borrowing costs and lower firm value.

Question 37

What is under-investment (the debt overhang problem), and why does it occur?

Answer 37

**Under-Investment (Debt Overhang Problem):** Occurs when a financially distressed firm avoids investing in a positive NPV project because most of the benefits go to debt holders rather than equity holders. **Why Won’t Equity Holders Invest?** * Equity holders must contribute, but the value increase mainly helps debt holders. * They prefer not to invest at all, even if the project is good for the firm. **Why Is This Called "Debt Overhang"?** * A high level of debt discourages equity holders from funding profitable projects. * Equity holders don’t invest because they know most benefits pay off debt holders. Firms with excessive debt may miss valuable investment opportunities, harming long-term growth.

Question 38

What is "Cashing Out," and how does it impact firm value and financial distress?

Answer 38

**Cashing Out:** * In financial distress, shareholders extract value by selling assets (often below market value) and paying themselves dividends instead of reinvesting. * Why? Shareholders lose everything if the firm defaults, so they take cash while they can, at the expense of debt holders. **Effects:** * Worsens under-investment (less reinvestment). * Depletes firm value (assets sold at discounts). * Increases bankruptcy risk. Conclusion: Cashing out benefits equity holders in the short term but harms debt holders and long-term firm value.

Question 39

How do agency costs of leverage arise, and how can they be addressed?

Answer 39

Conflicts between equity and debt holders reduce firm value: * Equity holders may take excessive risks. * Debt holders demand higher interest rates or restrict funding. * Lower share prices shift costs to shareholders. * Costs rise near default. Mitigating Agency Costs 1. Debt Covenants: Reduce conflicts but limit flexibility. 1. Debt Maturity: Short-term debt lowers agency costs; long-term debt increases them.

Question 40

How does leverage help maintain ownership concentration and align incentives?

Answer 40

* Leverage allows original owners to maintain their equity stake instead of diluting ownership through new share issuance. * Major shareholders have a strong incentive to act in the firm’s best interest. Leverage aligns management incentives with shareholder interests by preserving ownership concentration and motivating effort.

Question 41

How does leverage reduce agency costs in large corporations?

Answer 41

In large corporations, managers may make negative-NPV (unprofitable) investments due to agency problems. **Reasons for Such Investments:** 1. Empire building – Managers prefer larger firms for prestige, higher salaries, and publicity. 1. Expansion risks – Leverage prevents unprofitable acquisitions, overhiring, and excessive capital expenditures. **How Leverage Helps:** * Limits wasteful spending by restricting available free cash flow. * Forces managers to focus on profitability to meet debt obligations. Debt financing disciplines management by reducing access to excess capital, thereby curbing inefficient spending.

Question 42

What is the Free Cash Flow Hypothesis, and how does leverage impact managerial behavior?

Answer 42

The Free Cash Flow Hypothesis states that firms with excess free cash flow are more likely to engage in wasteful spending after covering all profitable investments and debt payments. **Impact of Leverage:** * Reduces wasteful spending by forcing managers to allocate cash efficiently. * Limits managerial entrenchment by increasing the risk of financial distress, making managers more accountable. * Increases monitoring since creditors closely oversee managerial actions in highly leveraged firms. Debt disciplines management by reducing available free cash flow for unproductive investments, leading to better capital allocation.

Question 43

How does the level of leverage affect firm value according to the Free Cash Flow Hypothesis?

Answer 43

* **Too Little Leverage:** Excess cash may lead to wasteful spending, "empire building," and poor investments. * **Optimal Leverage:** Balances tax benefits with financial stability, ensuring efficient capital allocation. * **Too Much Leverage:** Heightens financial distress risk, excessive risk-taking, and under-investment. An optimal capital structure balances debt benefits (tax shield, discipline) with risks (distress, agency costs).

Question 44

What is the Management Entrenchment Theory, and how does it affect capital structure decisions?

Answer 44

The Management Entrenchment Theory suggests that managers **structure capital to protect their job security rather than maximizing shareholder value**. **Implications:** * Avoiding high leverage to reduce the risk of financial distress, which could lead to job loss. * Cannot use too little debt, as shareholders expect some leverage to maintain financial discipline. * Firms may not always follow the optimal capital structure predicted by the tradeoff theory. Managers prioritize job security over firm value, leading to suboptimal financing choices.

Question 45

What is the Signaling Theory of Debt, and how does it work?

Answer 45

* Due to asymmetric information, managers often know more about the firm’s future than investors. * Investors doubt the firm’s true value, leading to the need for credible signals. **Credibility Principle:** * Actions are credible only if they impose costs that a dishonest firm wouldn’t bear. * "Actions speak louder than words." **Signaling Theory of Debt (Ross, 1977):** * Firms with profitable future projects but unable to disclose details use debt as a signal. * High debt signals confidence: 1. A truly profitable firm can handle debt payments. 2. A weak firm risks financial distress, making high debt unsustainable. Since financial distress is costly, only firms with strong prospects take on high debt, making leverage a reliable signal to investors.

Question 46

How does adverse selection affect equity issuance?

Answer 46

**Application to Equity Markets:** When firms issue new equity, investors suspect adverse selection: * A startup founder selling 70% of his stake may be seen as cashing out before bad news. * Investors buy only at a discount, assuming the worst. **Implications for Firms Raising Capital:** * Good firms avoid issuing equity to prevent selling at a discount. * Only weak firms (low-value securities) issue equity. * The cost of raising capital increases as investors demand a discount, assuming bad news. Issuing equity signals potential weakness, making investors skeptical and raising financing costs.

Question 47

What are the implications of equity issuance based on the lemons principle?

Answer 47

Market Implications of Equity Issuance and Information Asymmetry * **Stock Price Drop on Equity Issuance:** Investors suspect firms issuing equity may have negative private information, leading to a price decline. * **Stock Price Rise Before Issuance:** Firms time equity issuance after price increases; investors may anticipate it if the rise lacks fundamental justification. * **Issuing Equity with Reduced Asymmetry:** To mitigate skepticism, firms issue equity when financial transparency is highest, often post-earnings announcements. Firms strategically time equity issuance to minimize negative price effects and investor doubts.

Question 48

What is the Pecking Order Theory, and how does it influence financing decisions?

Answer 48

The Pecking Order Theory states that firms choose financing methods based on perceived equity value: * If equity is underpriced, firms prefer to use retained earnings or debt rather than issuing new equity. * If equity is overvalued, firms prefer to issue new equity as a funding source. **Hierarchy of Financing (Pecking Order):** 1. Retained earnings (internal funds) 1. Debt (borrowing) 1. Equity (issuing new shares – last resort) **Implications for Capital Structure:** * Highly profitable firms may have low leverage as they generate enough retained earnings to finance growth. * Firms with limited debt capacity may be forced to issue new equity, even if it is not the preferred choice. The Pecking Order Theory does not predict an optimal capital structure but explains financing preferences based on asymmetric information.

Question 49

What is the Market Timing Theory of capital structure?

Answer 49

The Market Timing Theory **suggests that a firm's capital structure is influenced by the market conditions present** when it sought financing. Implications: * Similar firms in the same industry can have very different capital structures, depending on **when they accessed funding.** * A firm may issue equity when stock prices are high and borrow debt when interest rates are low, shaping its long-term capital structure.

Question 50

What are the key determinants of optimal capital structure?

Answer 50

Capital structure is shaped by market imperfections, including: 1. **Taxes** → Incentivizes debt financing due to the interest tax shield. 1. **Financial distress costs** → Tradeoff Theory: Firms balance tax benefits of debt against financial distress risks. 1. **Agency costs** → Free Cash Flow Theory: Debt reduces managerial inefficiencies by limiting excess free cash flow. 1. **Asymmetric information** → Pecking Order Theory: Firms prefer internal financing first, then debt, and issue equity only as a last resort. Each factor influences how firms structure their debt-to-equity ratio.