Week 7 and 8 Flashcards
(10 cards)
What is the difference between debt and equity?
Equity is souced through ownership e.g. shareholders. Debt has to borrow money.
Debt has fixed interest payments. Equity is dividends + share price gains, so financially different.
Debt is tax deductible, equity is not.
What is the concept of beta in CAPM?
the relationship between expected return and risk. The sensitivity of an assets return to movements in the market portfolio. Basically measures how a security responds to movements in the market portfolio.
When B<0 moves in opposite direction to market.
When B=0 No risk as uncorrelated with that if market.
When B>0 but B<1 moves same direction but less than movement of market.
When B=1 moves same direction as market, giving same returns as market.
When B>1 moves same direction bur greater movement than that of market, increases cost of equity.
What is WACC?
average rate a company expects to pay to finance its assets, weighted by proportion of debt and equity in its capital structure. It is used as a discount rate to assess whether a project generates sufficient returns. If a projects returns exceed WACC, it adds value.
Assumptions:
Capital structure remains constant
Firms systematic risk reflected in beta doesnt change
Perfect capital markets- no taxes, no transaction costs, no bankruptcy costs
Tax rate is constant
All financing is available
What is cost of equity and cost of debt?
Cost of equity: return required by shareholders using CAPM e.g. Rf + B(Rm-Rf)
Cost of debt: interest rate firms pay on its borrowings
e.g. Rf + debt spread
Equity is riskier thus more expensive, debt is cheaper but increases financial risk.
CAPM assumptions:
-diversified portfolios
-markets are efficient
-single-period investment horizon
What is levered vs unlevered firms?
Levered: has a mix of both debt and equity for its financing, usually has a higher beta.
Unlevered: has only equity for its financing.
What was MM with no taxes proposition 1 and 2?
Proposition 1: The debt to equity ratio structure is irrelevant, the capital structure basically is irrelevant as no tax benefits.
Assumptions: no tax, no bankruptcy costs, no agency/info problems, no arbitrage opportunities, financing decisions is irrelevant in perfect capital markets.
Proposition 2: WACC stays constant regardless of D/E ratio. Cost of equity increases with leverage, debt to equity ratio.
MM proposition with taxes?
Proposition 1: Having more debt is better because of the tax shield which suggests levered firms are better than unlevered firms, where debt is tax deductible.
Proposition 2: the more debt in the ratio, the lower the WACC, making it better for funding projects. Good as we want WACC to be as low as possible.
Optimal capital structure is where financing is done by 100% debt due to deductibility of debts interest payments from taxation.
What are disadvantages of MM with taxes?
Bankruptcy if a firm cannot pay off its debt as they may have too much, can also offset tax benefits. Firms have to consider trade-off between debt and bankruptcy trade off. Additional debt is only good up until a certain point.
Legal and administrative costs of bankruptcy e.g. Lehman brothers total fees were $1.05 billion.
Other costs such as lost sales, suppliers and customers lose trust. Increases cost of doing business.
What is the trade off theory?
Too much debt increases probability of bankruptcy. Trade off between tax benefits of debt and bankruptcy costs. Optimal capital structure does exist.
Conflicts between shareholders and debt holders can cause agency problems.
Market value of a firm initially increases up until a certain point , eventually where tax benefits are offset by rising distress costs due to additional borrowing.
Profitable firms with valuable tangible assets borrow more.
Financial leverage is positively related to firm size, asset tangibility, and investment opportunities.
What is the pecking order theory?
Managers know more than an outside investor about the prospects of the firm so there is an asymmetric information problem. If equity is overvalued managers tend to issue equity.
Focuses on using internal financing first, then issuing debt, then using equity as a last resort. Profitable firms borrow less. Optimal capital structure does not exist.
Financial leverage is negatively related to bankruptcy probability
and R&D investments.
