Introduction to corporate finance and capital markets - Capital structure
13 important questions on Introduction to corporate finance and capital markets - Capital structure
What is senior debt?
What are the four advantages of senior debt financing?
- Inexpensive
- Easily accessible
- Standardised (every bank knows everything about a mortgage)
- Low transaction costs
What are the three disadvantages of senior debt financing?
- Restrictive covenants (a promise)
- Asset-oriented (you NEED assets)
- Amortising (you need to pay it back)
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What are the five advantages of mezzarine financing structures?
- Long-term capital
- Limited dilution to shareholders
- No amortisation
- Flexible coupon structures (annual interest payment of a bond)
- Minority/non-control investors
What are the two disadvantages of mezzanine financing structures?
- May mean shareholder dilution happens if certain targets are met or not met
- Not standardised (therefore often involving high transaction costs)
What are the two advantages of equity financing structures?
- Long term capital (you cannot finance a business with long-term capital and then ask it back, so cash can be used long-term),
- No principal repayment
What are the four disadvantages of equity financing structures?
- Dilutive/expensive (if another shareholder comes, you can lose a percentage of your shares because you decide to not top up when the business was raising money)
- Any changes involve high transaction costs (no standardisation, lawyer costs etc)
- Control mechanism (stakeholders have the right to vote once a year)
- Board seats
What is the order from lowest risk, lowest expected return to highest risk, highest expected return?
- Senior debt
- Mezzanine capital
- Subordinated debt, such as high yield bonds
- Convertible structures, such as subordinated debt + warrants
- Preference shares
- Ordinary shares
What is a tax shield?
Cost of debt is tax-free.
As the cost of debt is tax-deductable, this means that the actual cost of debt is:
- CD = Cost of debt
- RD = Rate on debt (i.e. interest rate)
- TC = Corporate tax rate
If a company has 1 equity and 99 debt, what does the bank and shareholders think?
The determination of optimal leverage in practice also takes the following elements into account:
- Business cycle
- Corporate investment policy
- Debt payback policy
- Covenants
- Debt structuring (senior, subordinated, convertibles)
- Commercial strategy of the lender (does a bank want to be prudent or win market share with respect to major customers?)
What is the difference between preferred shares and ordinary shares?
- Preferred shares are entitled to dividend payment sooner, so not voting rights.
- Ordinary shares do have voting rights, so higher expected return but also high risk.
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