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capital structure
the mix of long-term debt and equity financing
If you add up the market values of all the firm's debt and equity securities, you can calculate the value of all the future cash flows from the firm's real ___. In fact, the value of those cash flows ___ the value of the firm, and, therefore, determines the aggregate value of all the firm's outstanding debt and equity securities.
assets and operations, determines
If the firm changes its capital structure- say, by using more debt and less equity financing- overall value ___.
should not change
The value of a firm does not depend on how its cash flows are "___."
sliced
When there are no taxes and capital markets function well, the market value of a company does not depend on its ___. In other words, financial managers cannot increase value by changing the ___ used to finance the company.
capital structure, mix of securities
process of changing the firm's capital structure without changing its real assets
restructuring
If the company goes ahead and borrows, it will not allow investors to do anything that they could not already do, and so it cannot ___ the value of the firm.
increase
As long as investors can borrow or lend on their own account on the same terms as the firm, they are not going to pay ___ for a firm that has borrowed on their behalf.
more
The value of the firm after the restructuring must be the ___ as before. In other words, the value of the firm must be ___ by its capital structure.
same, unaffected
under ideal conditions, the value of a firm is unaffected by its capital structure
mm's proposition 1 (debt-irrelevance proposition)
Restructuring does not affect ___, regardless of the state of the economy.
operating income (business risk)
With less equity outstanding, a change in operating income has a ___ on earnings per share.
greater impact
Financial Leverage
leverage amplifies the effects of changes in operating income on the returns to stockholders (debt financing)
Debt financing does not affect operating risk but it does add ___. With only half the equity to absorb the same amount of operating risk, ___.
financial risk, risk per share must double
Financial Risk
risk to shareholders resulting from the use of debt
Because the restructuring does not change operating earnings or firm value, it should not change ___ either.
cost of capital
If you own all the debt and equity, you will effectively own all the ___ and receive all the ___.
assets, operating income
MM's proposition 1 states that the firm's choice of capital structure does not affect the firm's operating income or the value of its assets. So r(assets), the ___, is unaffected
expected return on the package of debt and equity
the required rate of return on equity increases as the firm's debt-equity ratio increases
mm's proposition 2
Debt increases financial risk and causes shareholders to ___. Once you recognize this implicit cost, debt is no cheaper than equity- the return that investors require on their assets is unaffected by the firm's borrowing decision.
demand a higher return on their investment
The implications of MM's proposition 2 is that no matter how much the firm borrows, the expected return on the package of debt and equity, r(assets), ___, but the ___ on the separate parts of the package does change. This is because the proportions of debt and equity in the package are also changing.
is unchanged, expected rate of return
More debt means that the ___, but at the same time the amount of equity is less.
cost of equity increases
At higher debt levels, lenders become concerned that they may not get their money back and they ___.
demand higher rates of interest
As the firm borrows more, the ___ increases and the firm has to pay higher interest rates.
risk of default
The expected return on equity ___ when debt is risky because the debtholders take on part of the risk. The expected return on the package of debt and equity, r(assets), ___.
increases more slowly, remains constant
Debt is not ___ financing.
cheap
Cost of debt depends on the firm's ___, while opportunity cost of capital depends on ___.
creditworthiness, the risk of the proposed capital investment
Substituting debt for equity financing creates financial risk even if the risk of default is ___.
zero
Debt financing has one important advantage:
the interest that the company pays is a tax-deductible expense, but equity income is subject to corporate tax
Interest Tax Shield
tax savings resulting from deductibility of interest payments
Rebalancing means future debt and interest tax shields are no longer ___; they vary with the firm's performance, and, therefore, should be discounted at a rate ___.
fixed amounts, higher than the cost of debt
___ reduces the firm's tax bill and increases the cash payments to the investors. The present value of these tax savings is captured by the firm's shareholders.
borrowing money
Borrowing increases ___.
firm value and shareholders wealth
When a company has no ___, the WACC and the return required by shareholders are identical.
debt
occurs when promises to creditors are broken or honored with difficulty
financial distress
At moderate debt levels the probability of financial distress is trivial, and therefore, the tax advantages of debt ___.
dominate
Trade-Off Theory
debt levels are chosen to balance interest tax shields against the costs of financial distress
managers will try to increase debt levels to the point where the value of additional interest tax shields is exactly offset by the additional costs of financial distress
trade off theory
In principle, bankruptcy is merely a legal mechanism for allowing creditors (lenders) to take over the firm when the decline in the value of its assets triggers a ___.
default on outstanding debt
What are old stockholders left when bankruptcy occurs?
nothing
The more a firm owes, the higher the chance of default and, therefore, the greater the expected value of the associated costs. This reduces the current ___ of the firm.
market value
Creditors foresee the costs and realize that if default occurs, the bankruptcy costs will come out of the value of the firm. For this, they demand compensation in advance in the form of ___. This reduces the possible ___ and reduces the current market value of their shares by the present value of the expected future default costs.
higher promised interest rates, payoff to stockholders
Financial distress is costly when these conflicts get in the way of ___.
running a business
firms threatened with default are tempted to shift to riskier investments
risk shifting
firms threatened with default may pass up positive-NPV projects because bondholders capture part of the value added
debt overhang
agreement between firm and lender requiring the firm to fulfill certain conditions to safeguard the loan
loan covenant
The most profitable companies generally borrow the ___.
least
Pecking Order Theory
firms prefer to issue debt rather than equity if internal finance is insufficient
Pecking Order Theory- Firms prefer ___. Reinvesting earnings does not send adverse signal that could ___ the stock price.
internal financing, lower
Pecking Order Theory- If external finance is required, firms issue debt first and issue equity only as a last resort. This pecking order arises because an issue of debt is less likely than an equity issue to be interpreted by investors as a ___.
bad omen
Less profitable firms issue debt because they do not have ___ for their capital investment program and because ___ is first in the pecking order for ___ finance.
sufficient internal funds, debt, external
For most US corporations, ___ finance the majority of new investment, and most external financing comes from ___.
internal funds, debt
The pecking order theory works best for ___.
mature firms
You wouldn't expect the ___ to apply to firms with extremely valuable growth opportunities.
pecking order
Stock issues by growth firms do not send the same ___ as issues by mature firms.
pessimistic signal
Firms that have worked down the pecking order and need external capital may end up living with ___ or bypassing good investments because shares can't be sold at what managers consider a fair price.
excessive debt
ready access to cash or debt financing
financial slack
companies with ample cash flow are tempted to overinvest and to operate inefficiently; companies facing this problem may benefit from the discipline imposed by more debt and higher debt-service requirements
free-cash-flow problem
