ACF 1, 2 + 3: Capital structure in perfect + imperfect markets

  • Created by: charlie
  • Created on: 01-05-18 09:42
M&M Proposition 1: Irrelevance of capital structure in perfect markets
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M&M Proposition 1 proof: Investors can 'undo' firms capital structure
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Are M&M propositions valid if debt is risky?
Using risky debt = cost of financial distress (bankruptcy)
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Beyond M&M Proposition 1 (imperfect capital markets)
1) Financing decisions influence stock prices 2) Taxes affect financing
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Beyond M&M Proposition 1: taxes
1) Corporate taxes 2) Personal taxes
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Beyond M&M Proposition 1 proof: investors unable to 'undo' firms capital structure
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Financial distress costs: assumptions (2)
1) Managers act inline with SH (max value) 2) Conflicts of interests/ agency costs occur at very high debt levels
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Financial distress defintion
difficulty in making interest payments to debt holders who are legally obliged to make interest payments (leads to bankruptcy) and lowers firm value
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Financial distress costs: type 1
1) Direct bankruptcy costs (fees for wind-down): lawyers, accountants, consultants...
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Financial distress costs: type 2
2) Indirect bankruptcy costs (agency costs DH vs SH): SH exploit DH through 2 channels
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Financial distress costs: type 2: SH exploit DH through 2 channels
1) Tendency to take high risk (risk-shifting/ asset substitution) 2) Underinvestment (debt overhang)
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Conflicts of interests/ agency costs don't always hold
DH + SH may be same individual (e.g. German banks and main lenders + hold shares in companies)
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How can DH/ SH gain bargining power
DH: charge higher req ROR on their debt / SH: force managers to liquidate and payout dividends
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Other issues from high financial distress risk caused by SH (2)
1) Push for ST less-profitable investment projects at expense of LT firm value 2) Push to not liquidate despite operating value < liquidation value (DH get paid first)
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How firms can minimise conflicts of interest/ agency cost issue (6)
1) Protective covenants (contracts) 2) Privately held debt (more info) 3) ST debt (bargaining power) 4) security design (DH + SH same investor) 5) project financing (separate monitoring) 6) management compensation (options/ other contracts)
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Other cards in this set

Card 2

Front

M&M Proposition 1 proof: Investors can 'undo' firms capital structure

Back

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Card 3

Front

Are M&M propositions valid if debt is risky?

Back

Preview of the front of card 3

Card 4

Front

Beyond M&M Proposition 1 (imperfect capital markets)

Back

Preview of the front of card 4

Card 5

Front

Beyond M&M Proposition 1: taxes

Back

Preview of the front of card 5
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