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Terms in this set (11)
Explain two ways in which debt could increase WACC and two ways in which it could decrease WACC.
-Debt holders have a prior claim on CFs relative to stockholders
-Debt increases risk of bankruptcy
-Firms can deduct interest expenses
-More debt causes shift from more expensive equity to less expensive debt.
How can debt in the capital structure make the agency problem better? How can debt in the capital structure make the agency problem worse?
Helps with overinvestment (debt musts be paid and stops from making investment that only for personal benefit)
Makes things worse by underinvesting (stops the risky investments with high rewards which may increase debt)
Why do corporate taxes favor debt financing rather than equity financing?
because only interest payments on debt are tax-deductible not dividend payments to shareholders
Why do personal taxes favor equity financing rather than debt financing?
-Increases in a share price are not taxed or reported until the stock is sold.
-Capital gains taxes are paid in the future and the present value of future taxes paid is lower than tax payments made today
What does the trade-off theory say about the optimal capital structure? What two items are being "traded off"?
That firms should increase their leverage until it reaches the amount that maximizes firm value
You are trading off tax savings to offset financial distress
What impact does asymmetric information have on the optimal capital structure?
High asymmetric information are likely to use more debt in their capital structure (if needs exceed internal retained earnings)
Explain why a growing firm would most likely want to have a larger borrowing capacity than a stable (low growth) firm.
Because they are looking to raise debt in the future once they find investment opportunities
According to market timing, what actions do managers believe are appropriate when stock prices are too high or too low?
Issue equity when price is high and Issue debt when price is low
What effect does the increase of debt have on the cost of Equity? why?
creates an increase in cost of equity (Because shareholders have smaller cash flows as the level of debt is increased)
According to the trade-off theory, the optimal capital structure is one which balances the benefits of debt from _______________________ with the drawback of debt from ______________________.
Tax deductibility of interest; bankruptcy risk.
Which of the following M&M models do not suggest nearly 100% debt as the optimal level of debt financing?
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