1 - Does Debt Policy Matter

Question 1

What does a firms capital structure consist of?

Answer 1

the mixture of debt and equity and other securities that make up the financing side of the balance sheet

Question 2

What does Modigliani & Miller (1956) discuss?

Answer 2

Firm Capital Structure, Firm value and WACC

with and without tax

Question 3

What is the first proportion by Modigliani & Miller (1956)?

Answer 3

Proposition 1: market value of a firm is not affected by the capital structure of the firm.

Question 4

what are the seven assumptions that Modigliani & Miller (1956) make?

Answer 4

1 no taxes, corporate or personal.
2 no costs of financial distress.
3 no information asymmetry.
4 Bonds and stocks trade in perfect markets.
5 Investors can borrow and lend at the same rate.
6 There are no agency costs, either debt or equity.
7 Investment and financing decisions are independent of one another.

Question 5

what does Unlevered equity mean?

Answer 5

Equity in a firm with no debt

Question 6

If expected return and cost of capital are equal, what does this mean for shareholders?

Answer 6

shareholders are earning an appropriate return for the risk they are taking.

Question 7

what does Levered Equity mean?

Answer 7

Equity in a firm that also has debt outstanding

Question 8

What is the Law of One Price?

Answer 8

the combined values of debt and equity must be equal to firm value

Question 9

Does leverage increase the risk of equity in a firm? does leverage impact the return to shareholders

Answer 9

yes it does increase risk and impact returns - therefore shareholders will require a higher rate of return

Question 10

How is systematic risk shown?

Answer 10

strong return % - weak return %

Question 11

how is the risk premium shown?

Answer 11

E(return) - risk free rate

Question 12

What is the second proportion by Modigliani & Miller (1956)?

Answer 12

MM II: The cost of equity is a linear function of the firm’s debt/equity ratio

The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the market value debt-equity ratio.

Question 13

What is the formula for cost of cap for levered equity? Re

Answer 13

Re = R-unlevered + D/E (R-unlevered - R-debt)

Question 14

If a firm is unlevered what happens to free cash flows generated?

Answer 14

they are paid out to its equity holders

Question 15

What is the value for WACC?

Answer 15

WACC = (E/V x R-equity) + (D/V v R-debt)

Question 16

if there is no debt what is WACC equal to?

Answer 16

unlevered equity cost of cap

Question 17

what is a firm borrows at a low cost of debt? what happens to the equity cost of cap?

Answer 17

it increases so the overall WACC is unchanged

Question 18

what does the conservation of value outlined by MM?

Answer 18

in perfect cap markets, financial transactions neither add or destroy value - they simply repackage risk (and therefore return)

Question 19

what three things could cause a firm to have less leverage?

Answer 19

high growth
high profits
pay dividends

Question 20

what three things could cause a firm to have more leverage?

Answer 20

industry
asset tangibility
firm size - larger=more leverage

Question 21

What does Titman 2001 argue?

Answer 21

that according to MM, financing choice is irrelevant if:
(a) total cash flows are unaffected
(b) markets are efficient
If market is efficient financial intermediaries can costlessly repackage securities in a competitive market then firm’s financing choice is irrelevant.

Question 22

What does Titman 2001 argue for integrated markets?

Answer 22

required return premiums associated with any risk should be the same

Question 23

What is one example of imbalance in integrated markets?

Answer 23

Hong Kong 1980’s demand for levered bets > supply
Hong Kong market → no options, just warrants → warrants were overpriced due to demand → market is efficient but not complete
Japan → oversupply of warrants
America’s involvement solved this incomplete markets problem by buying from Japan and selling to Hong Kong

Question 24

where does Titman 2001 place more emphasis the Modigliani & Miller (1956)?

Answer 24

That markets are efficient: - (MM assumes perfect market)
The market can be efficient without being complete, but if the market is complete it becomes even more efficient

e.g. market analysts make the market more complete and therefore more efficient

Question 25

According to Titman 2001: does MM require complete or efficient markets?

Answer 25

only efficient markets

Question 26

what happens as the global economy becomes more integrated?

Answer 26

if the global market is more integrated, = more complete, efficiency increases

Question 27

What is an example of economy integration? Name a specific country that benefited and why?

Answer 27

European Union unified the currency, increases incentive to invest due to lower risk and ∴ increases liquidity
i.e. Greek → prior to integration tried to issue debt but no demand due to Greek debts being too risky (∴ incomplete)