Advanced Corporate Finance Essay
Questions
Trade-off theory - ANS Briefly explain what they have to say about capital
structure:
This Theory adds bankruptcy costs to the MM 1963 Corporate Tax framework.
The MM 1963 framework states that VL = VU + TcD. This means that the more
debt that you have in your capital structure, the higher firm value. The theory
expands off of that and adds cost for financial distress. The theory is that
there is a trade-off between the tax advantage of debt and the costs of
financial distress. The target of this theory is to have capital structure such
that the marginal benefit of debt (TcB) = Marginal Cost of Debt (Financial costs
of Distress) in order to have the optimal debt-to-equity ratio and maximize firm
value.
Signaling Theory - ANS Briefly explain what they have to say about capital
structure:
This theory is based on asymmetric information and states that firms will use
capital structure to signal their quality. Investors view debt as a signal of firm
value therefore firms with low anticipated profits will take on a low level of
debt and firms with high anticipated profits will take on a high level of debt.
, Agency Cost of Equity Theory - ANS Briefly explain what they have to say
about capital structure:
This theory states that an individual will work harder for a firm if he/she is one
of the owners rather than he/she is one of the "hired help." While managers
may have motive to partake in perquisites, they also need opportunity. Free
cash flow provides this opportunity. The free cash flow hypothesis says that
an increase in dividends should benefit the stockholders by reducing the
ability of the managers to pursue wasteful activities. It also argues that an
increase in debt will reduce the ability of managers to pursue wasteful
activities.
Pecking Order Theory - ANS Briefly explain what they have to say about
capital structure:
This theory states that the firms prefer to issue debt rather than equity if
internal financing is insufficient. The first rule of this is to use internal
financing if available. The second rule of this is to issue the safest securities
first and then issue debt next and then new equity last.
Trade-off theory - ANS How would each of these theories interpret an increase
in a firm's level of debt (in its capital structure)?
If the firms level of debt increased, the Trade-off theory would state that the
firm is below the optimal debt/equity ratio.
Questions
Trade-off theory - ANS Briefly explain what they have to say about capital
structure:
This Theory adds bankruptcy costs to the MM 1963 Corporate Tax framework.
The MM 1963 framework states that VL = VU + TcD. This means that the more
debt that you have in your capital structure, the higher firm value. The theory
expands off of that and adds cost for financial distress. The theory is that
there is a trade-off between the tax advantage of debt and the costs of
financial distress. The target of this theory is to have capital structure such
that the marginal benefit of debt (TcB) = Marginal Cost of Debt (Financial costs
of Distress) in order to have the optimal debt-to-equity ratio and maximize firm
value.
Signaling Theory - ANS Briefly explain what they have to say about capital
structure:
This theory is based on asymmetric information and states that firms will use
capital structure to signal their quality. Investors view debt as a signal of firm
value therefore firms with low anticipated profits will take on a low level of
debt and firms with high anticipated profits will take on a high level of debt.
, Agency Cost of Equity Theory - ANS Briefly explain what they have to say
about capital structure:
This theory states that an individual will work harder for a firm if he/she is one
of the owners rather than he/she is one of the "hired help." While managers
may have motive to partake in perquisites, they also need opportunity. Free
cash flow provides this opportunity. The free cash flow hypothesis says that
an increase in dividends should benefit the stockholders by reducing the
ability of the managers to pursue wasteful activities. It also argues that an
increase in debt will reduce the ability of managers to pursue wasteful
activities.
Pecking Order Theory - ANS Briefly explain what they have to say about
capital structure:
This theory states that the firms prefer to issue debt rather than equity if
internal financing is insufficient. The first rule of this is to use internal
financing if available. The second rule of this is to issue the safest securities
first and then issue debt next and then new equity last.
Trade-off theory - ANS How would each of these theories interpret an increase
in a firm's level of debt (in its capital structure)?
If the firms level of debt increased, the Trade-off theory would state that the
firm is below the optimal debt/equity ratio.
