w3 : capital structure ii Flashcards
what is financial distress?
face difficulty in meeting debt obligations but havent defaulted yet
compare reality to M&Ms proposition 1 in relation to defaulting.
M&M says no disadvantage to debt financing, bankruptcy is costless. in reality, bankruptcy imposes costs on investors. also higher leverage increases chance of default, so higher IR charged.
state the direct and indirect costs of bankruptcy.
direct - fees to accountants, lawyers etc
indirect - lost sales, damage to reputation, mgt time spent averting bankruptcy
why is it suggesteed that an optimal capital structure exists?
trade off theory. opposing effects of benefits of interest tax shield and costs of financial distress suggests optimal structure exists.
state the equation that can be used to calculate net benefit or optimal capital structure.
benefit - cost
PV (int. tax shield) - PV (financial distress costs)
what is the pecking order theory?
states that it is cheaper to use internal funds first. exhaust internal funds first, then use external.
capital structure is reflection of firms need for external finance
what is the order in pecking order theory?
- internal funds
- debt
- hybrids (convertibles)
- stock issue
what is the agency cost of debt?
conflict of interest between bondholders and shareholders.
what is the agency cost of equity?
conflict of interest between owners (SHs) and managers
state two examples of the agency cost of debt.
asset substitution problem
underinvestment problem
state an example of the agency cost of equity.
free cash flow
what is the asset substitution problem?
shareholders in company with outstanding debt own call (buy) option on assets of company. managers have incentive to accept negative NPV projects if close to bankruptcy.
when assets are substituted from bondholders to shareholders
what type of project would a bondholder prefer and why?
prefer a low risk project as their claim usually always met.
what type of project would a shareholder prefer and why?
prefer high risk project as higher payout. get residue once bondholders have been paid
what is the underinvestment problem?
equity holders (SHs) choose not to invest in positive NPV project because firm is in financial distresss, so value of undertaking investment will accrue to bondholders rather than themselves. SHs have less priority in payout compared to bondholders.
what is the free cash flow problem?
if FCF not paid out to investors, mgt more likely to abuse funds for their own benefit. eg. increase consumption of goods like jets
what are the two potential solutions to free cash flow problem?
- increase leverage or pay higher dividends
- align goals of mgt & SH
