1. Capital Structure Basics

Question 1

Assumptions for MM propositions

Answer 1

1. Perfect financial markets (rational, frictionless and competitive)
2. All agents have the same information
3. A firms’ cash-flow does not depend on its financial policy (e.g. no bankruptcy costs)
4. No taxes

Question 2

Four propositions

Answer 2

• MM-Proposition I: A firms’ total market value is independent of its capital structure
• MM-Proposition II: A firms’ cost of equity increases with its debt-equity ratio
• Dividend Irrelevance: A firms’ total market value is independent of its dividend policy
• Investor Indifference: Individual investors are indifferent to all firms’ financial policies

Question 3

MM proposition 1

Answer 3

• It doesn’t matter whether the cash flows are distributed through the debtholders (interest to debtholders) or equity shareholders (as dividend), all cash-flows eventually leaves the firm
• The real assets (left hand side of the balance sheet) determines the market value of the firm.

Question 4

MM proposition 2

Answer 4

• A firms’ cost of equity increases with its debt-equity ratio.
• The weighted average cost of capital (WACC) increases when the amount of debt is increasing.
• Higher debt makes the firm riskier, increasing the expected returns investors demand.

Question 5

Dividend irrelevance

Answer 5

• A firms’ total market value is independent of its dividend policy.
• Because the shareholder can always create (through home-made dividend) their own dividend returns

Question 6

Investor irrelevance

Answer 6

• Managers of a firm should not care about the preferences of individual investors.
• Individual investors can always (under the assumptions) take the same transactions as a company to create their own portfolio, with their own risk and returns.

Question 7

The message of MM

Answer 7

• Value is created only by operating assets, i.e. on Left Hand Side of the Balance Sheet.
• A firm’s financial policy should be (mostly) a means to support the operating policy, not an end itself.

Question 8

What happens to the propositions if we introduce taxes?

Answer 8

• If we introduce taxes, the propositions do not hold anymore.
• This is because interest on debt is tax deductible.
• The levered firm has to pay less taxes than the unlevered firm.
• The cash flows for the levered firm are higher than for the unlevered firm
• It is attractive for firms to leverage up

Question 9

What happens when you also subsidize equity?

Answer 9

2006 Belgium introduction the NID (Notional Interest Deduction) which allows firms equity deduction

• The NID led to a significant increase in the share of equity in the capital structure
• Both existing and new firms increase their equity ratios after the introduction of the NID
• The changes caused by the NID are the strongest at large and new firms
• The increase of the equity ratios is caused by an increase in equity and not by an increase of other liabilities

Question 10

What are bankruptcy costs?

Answer 10

Bankruptcy costs are legal and administration costs and the costs of losing sales when the firm goes bankrupt

Question 11

What happens to the propositions when we introduce information to agents?

Answer 11

The assumption “all agents have the same information” does not hold in a real world. This is because of asymmetric information.

Question 12

Asymmetric information consequence

Answer 12

Asymmetric information between a firm and the market makes external capital costlier than internal capital (retained earnings).

Question 13

Pecking order theory

Answer 13

Preferably use retained earnings first, then borrow from a debt market (debt is less sensitive to asymmetric information issues and is therefore cheaper) and as a last resort, issue equity. Equity is more expensive than debt, because it is riskier.