What is a very important assumption when examining the effects of borrowing?
We hold the firm's capital investments constant
What is an advantage to debt?
by having the owners put up less money, their returns gain the benefit of leverage (when corporate cash flows are large, leverage magnifies their return)
What is a disadvantage to debt?
when corporate cash flows are small, leverage magnifies losses
What is the Modigliani-Miller Proposition I?
- in a world of no taxes and transaction costs, the value of the firm is independent of its capital structure
- value is created by the assets, not by how it is financed
Why is value created by assets and not by how it is financed?
because financing is obtained in efficient security markets where no positive NPV's can be earned from simply issuing securities
What is the Modigliani-Miller Proposition II?
the relationship between the cost of equity for an unlevered firm and for a firm with leverage
What does M&M mean for companies?
a company should try to keep its cost of capital as low as possible (maximizing the value of firm is equivalent to minimizing the cost of capital);
What are two claimants on cash flows for firms that use debt?
creditors and shareholders
What are some factors that limit the use of debt?
- personal taxes
- bankruptcy costs
- financial distress
What is financial distress?
- costs associated with having financial problems that may or may not materialize into bankruptcy, such as:
- loss of credit from suppliers
- loss of customers
- loss of employees
What do stockholders of debt-heavy firms that have a high probability of bankruptcy have an incentive to do what?
- They gamble on negative-NPV projects b/c they have little to lose. The creditors bear most of the risk.
- Pass up positive-NPV projects b/c the gains primarily accrue to the creditors (underinvestment)
- Substituting risky assets for safe assets, which hurts bondholders and makes bankruptcy more likely
How are the sources of financing prioritized based on costs and signals they provide?
- first choice: internal equity
- second choice: external debt
- third choice: external equity
Why is external equity least preferred?
B/c of the view that management will sell new stock only when it is overpriced
What is internal equity?
It's like savings, representing what companies have previously earned. It can be spent with the fewest strings attached
What does the pecking order theory imply about dividends?
- companies have target dividends and adapt their payout policies to their investment opportunities
- dividends are rarely changed by large amounts
- firms draw on cash and then borrow if necessary to maintain steady dividends. If cash builds up, they increase dividends or just let cash build up