Capital Structure quiz

Pecking order theory is based on information asymmetry and the resulting signals that different financing choices send to investors. It suggests that retained earnings are the first choice for financing an investment and issuing new equity is the least preferred choice.

The market value of equity is (USD30)(10,000,000) = USD 300,000,000

With the market value of debt equal to USD 100,000,000

the market value of the company is USD 100,000,000 + USD 300,000,000 = USD 400,000,000.

Therefore, the company is USD 100,000,000/USD 400,000,000 = 0.25, or 25% debt-financed.

A firm should always finance a project based on the firm's weighted average cost of capital, although when evaluating a project, the firm may apply a risk factor to adjust the risk of the project. A corporate manager generally cannot deem some projects as being financed by debt and some by equity as all projects are effectively financed proportionately based on the firm's capital structure. In practice, a firm's actual capital structure will float around its target. For a firm that does have a target capital structure, the actual structure may vary from the target due to market value fluctuations, or management's desire to exploit an opportunity in a particular financing source.

As cash flows become more predictable, the company is able to support more debt in its capital structure; the optimal capital structure includes a higher proportion of debt. While mature companies do borrow to support growth, this action would typically not occur because the company is optimizing its capital structure. Likewise, while a mature company might issue equity to finance growth, this action would not be the typical approach for a company optimizing its capital structure .

An electric utility has the capacity to support substantial debt, with very stable and predictable revenues and cash flows. The software company also has these attributes, but it would have been much less likely to have raised debt during its development and may have raised equity. The mining company has fixed assets, which it would have needed to finance, but the cyclical nature of its business would limit its debt capacity .

Management is generally focused on maximizing the value of equity .

According to Modigliani and Miller's Proposition I, under certain assumptions, including the absence of taxes and bankruptcy costs, the value of a firm is unaffected by its capital structure .

For an analyst, target capital structure should always be based on market values of debt and equity. The other two choices are appropriate methods for estimating a firm’s capital structure for analysis .

The pecking order theory of capital structure assumes that firms have a preference ordering for capital sources. They prefer to use internally-generated equity first. When the internally-generated equity is exhausted, they issue new debt capital. As a last resort they will rely on externally-sourced equity. The reason that new equity is the last resort is that the issuance of new stock is assumed to send a negative signal to investors regarding firm value.

w_d =  63 / ( 220 +  63) = 0.223.

w_e =  220 / (220 + 63) = 0.777.

Market values should be used in cost of capital calculations, and forecasted market values should be used in this case given that the cost of capital will be applied to projected cash flows in McClure’s analysis.

Proposition I, or the capital structure irrelevance theorem, states that in perfect markets the level of debt versus equity in the capital structure has no effect on company value .

A company’s optimal and target capital structures may be different from each other

The static trade-off theory indicates that there is a trade-off between the tax shield for interest on debt and the costs of financial distress, leading to an optimal amount of debt in a company’s capital structure .

Mature companies are able to support more debt than start-up companies or growth stage companies because they typically have predictable positive cash flows, lower business risk, and significant liquid assets .

The static trade-off theory seeks to balance the costs of financial distress with the tax shield benefits from using debt. Under the static trade-off theory, there is an optimal capital structure that has an optimal proportion of debt that will maximize the value of the firm.

According to the pecking order theory, internally generated funds are preferable to both new equity and new debt. If internal financing is insufficient, managers next prefer new debt, then new equity. Managers prefer forms of financing with the least amount of visibility to outsiders .

Long-term debt is more exposed than short-term debt to the risk of a management decision that is not debtholder-friendly. Secured debt is less exposed than unsecured debt to such a risk, and with low leverage, the risk of a debt-equity conflict is reduced, not increased, relative to high leverage .

Companies generally raise capital when it is needed, such as for investment spending or when market pricing and terms are favorable for debt or equity issuance.