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Principles of finance > week 8 > Flashcards

week 8 Flashcards

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1
Q

What is capital structure?

A

The mix of debt and equity a firm uses to finance its operations.

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2
Q

Why use both debt and equity?

A

Diversifies risk, lowers overall cost of capital, and balances control and obligations.

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3
Q

Why is interest on debt tax-deductible?

A

Because interest is an expense, it reduces taxable income, acting as a tax shield.

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4
Q

What is the tax shield formula?

A

Tax Shield = Interest Expense × Tax Rate.

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5
Q

What is financial leverage?

A

The extent to which a firm uses debt. More debt = higher leverage.

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6
Q

What is overleveraging?

A

When a firm uses too much debt, increasing bankruptcy risk.

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7
Q

What is underleveraging?

A

Using too little debt, possibly missing out on growth opportunities from cheaper financing.

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8
Q

How does more debt affect financial risk?

A

Increases financial risk and potential bankruptcy.

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9
Q

How does equity dilute ownership?

A

Issuing more equity means existing owners own a smaller share of the business.

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10
Q

Why are loans more attractive in the EU and UK?

A

Due to stricter bond/equity regulations compared to the US.

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11
Q

Why is debt common in Japan?

A

Interest rates are extremely low or negative, making debt very cheap.

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12
Q

What is active capital structure management?

A

Restructuring capital, e.g., issuing debt to buy back shares or vice versa.

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13
Q

What is passive capital structure management?

A

Letting capital structure shift over time through new financing choices.

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14
Q

Example of active capital restructuring?

A

Issue $5M debt to buy back $5M in equity to move from 100% equity to 50/50 debt/equity.

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15
Q

Example of passive capital change?

A

Add $10M debt to finance future growth without changing existing equity.

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16
Q

What are flotation costs?

A

Fees for issuing new securities (underwriting, legal, etc.).

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17
Q

Why do fast-growing firms often passively change structure?

A

They regularly raise capital, naturally altering their capital mix.

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18
Q

What is the Modigliani-Miller (M&M) theorem?

A

Capital structure is irrelevant in a perfect market with no taxes or bankruptcy.

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19
Q

M&M Proposition I (perfect world)?

A

Value of a leveraged firm = value of an unleveraged firm. Capital structure doesn’t affect value.

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20
Q

M&M Proposition II (perfect world)?

A

Cost of equity increases linearly with debt (D/E) due to higher risk.

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21
Q

How does leverage affect WACC in M&M’s perfect world?

A

WACC remains unchanged, as cheap debt is offset by rising cost of equity.

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22
Q

What changes in M&M with corporate taxes?

A

Interest becomes tax-deductible; debt adds value via the tax shield.

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23
Q

M&M Proposition I (with tax)?

A

Firm value increases with more debt: VL = VU + D × Tc.

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24
Q

What is the formula: VL = VU + D × Tc?

A

VL = value of leveraged firm, VU = unleveraged firm value, D = debt, Tc = corporate tax rate.

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25
M&M Proposition II (with tax)?
Cost of equity still increases with leverage, but less sharply due to the tax shield benefit.
26
What if we also add bankruptcy risk to M&M?
Too much debt reduces value due to financial distress costs.
27
What are costs of financial distress?
Legal fees, lost customers, strained supplier terms, employee turnover.
28
What happens to firm value with excessive debt?
Value decreases as financial distress outweighs tax benefits.
29
What does the green line represent (capital structure graph)?
Value of the firm with tax benefits but without distress costs.
30
What does the blue line represent (capital structure graph)?
Real firm value after subtracting financial distress costs.
31
What is the optimal capital structure?
The point where the firm’s value is maximized — balance between debt benefits and distress costs.
32
How did Apple manage capital structure in 2013?
Issued $17B in debt despite having $145B in cash to fund buybacks and avoid U.S. tax.
33
Why was Apple’s 2013 debt issuance smart?
Took advantage of low interest rates and tax laws to increase shareholder value.
34
Why does debt increase risk and return?
More capital to invest = higher potential profit; but also higher risk of default.
35
Why is debt cheaper than equity?
Debt has fixed payments, lower risk for lenders, and no participation in upside.
36
How does debt affect cost of equity?
Increases it — shareholders demand higher return due to increased risk.
37
How should firms with high tax rates structure capital?
Use more debt to maximize tax shield benefits.
38
What kind of firms can safely use more debt?
Firms with stable and predictable income (e.g., utilities).
39
What is the Modigliani–Miller (M&M) Theorem?
A capital structure theory that states under perfect conditions, a firm’s value is independent of its capital structure.
40
What is a perfect capital market in M&M theory?
No taxes, no bankruptcy costs, no transaction costs, symmetric information, and rational investors.
41
M&M Proposition I (perfect market) formula
VL = VU — The value of a leveraged firm equals the value of an unleveraged firm.
42
M&M Proposition II (perfect market) formula
Re = Ra + (Ra – Rd)(D/E) — Cost of equity increases linearly with debt.
43
In M&M Prop II, what do Ra, Re, and Rd stand for?
Ra: return on assets; Re: return on equity; Rd: cost of debt.
44
What happens to WACC in a perfect market?
WACC remains constant regardless of capital structure.
45
Why does WACC stay constant in a perfect market?
Cheap debt is offset by increased cost of equity due to higher risk.
46
What changes in M&M Proposition I with corporate taxes?
VL = VU + D × Tc — Firm value increases with more debt due to tax shield on interest.
47
How does tax shield affect capital structure?
More debt increases value by saving taxes: Tax Shield = Interest × Tax Rate.
48
What happens to optimal capital structure with corporate taxes?
100% debt would theoretically maximize value due to full tax shield.
49
What happens to M&M theory when bankruptcy is included?
Too much debt reduces value due to expected financial distress costs.
50
How does financial distress affect firm value?
Causes legal costs, customer loss, supply issues, and credit restrictions, lowering value.
51
How does M&M Proposition I change with taxes and bankruptcy?
VL = VU + D × Tc – PV(Financial Distress Costs).
52
What is the key trade-off in capital structure decisions?
Benefit of tax shield vs. cost of financial distress.
53
Describe the D/E vs. Firm Value graph
Value rises with D/E due to tax benefits, peaks at optimal D/E, then falls due to distress costs.
54
What does the green line on the M&M graph show?
Theoretical firm value with taxes but no distress — continues to rise with more debt.
55
What does the blue line on the M&M graph show?
Realistic firm value with taxes and distress — rises, then falls after optimal point.
56
Where is the optimal capital structure on the M&M graph?
The peak of the blue line — max value before distress outweighs tax benefits.
57
How do credit ratings influence capital structure in reality?
High debt can lower ratings, raising cost of borrowing and reducing flexibility.
58
What is financial flexibility?
A firm's ability to access funding when needed without damaging operations or value.
59
Why does real-world capital structure deviate from M&M?
Due to taxes, bankruptcy risk, asymmetric info, agency costs, and market imperfections.
60
How does capital structure affect shareholder return?
More debt increases financial leverage, magnifying returns — and losses.
61
How do flotation costs affect capital structure changes?
Costs of issuing debt or equity influence whether a firm adjusts structure actively.
62
Why might a firm use passive capital structure management?
To avoid high flotation costs or disruptive market signals.
63
How does cost of equity change with leverage?
Increases, as shareholders bear more risk — higher expected return.
64
How does cost of debt change as leverage increases?
Increases eventually due to greater default risk perceived by lenders.
65
Why can't firms use 100% debt in real life?
Financial distress and agency costs make high debt too risky.
66
Why might a tech company prefer equity over debt?
Unpredictable cash flows make fixed interest payments risky — equity is safer.
67
How does the WACC curve behave in real life?
U-shaped — falls with moderate debt, rises after optimal point due to distress risk.
68
What is the goal of capital structure management?
Minimize WACC and maximize firm value by balancing debt and equity.

Principles of finance (10 decks)

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