2. Capital Structure Flashcards
Explain the Modigliani-Miller (MM) proposition Number 1 (No Taxes): The Capital Structure Irrelevance Proposition.
Which are the assumptions of this proposition?
The Capital Structure Irrelevance Proposition suggests that in a perfect world, it does not matter how a firm finances its operations. Thus, capital structure is irrelevant.
VL = VU
Value of Levered firm = Value of Unlevered Firm
MM’s study is based on the following assumptions:
- Capital markets are perfectly competitive, there are no transactions costs, taxes, or bankruptcy costs
- Investors have homogeneous expectations, they have the same expectations with respect to cash flows generated by the firm
- Riskless borrowing and lending: investors can borrow/lend at the risk-free rate
- No agency costs: no conflict of interests between managers and shareholders
Explain the Modigliani-Miller (MM) proposition Number 2 (No Taxes): Cost of Equity and Leverage Proposition
Which are the assumptions of this proposition?
MM’s second proposition with no taxes states that the cost of equity increases linearly as a company increases its proportion of debt financing. Again, MM assume a perfect market where there are no taxes, no cost of bankruptcy, and homogeneous expectations. Debtholders have a priority claim on assets and income, which makes the cost of debt lower than the cost of equity. However, as companies increase their use of debt, the risk to equityholders increases, which in turn increases the cost of equity. Therefore, the benefits of using a larger proportion of debt as a cheaper source of financing are offset by the rise in the cost of equity, resulting in no change in the firm’s WACC.
Re = R0 + D/E*(R0-Rd)
Re = required rate of return on equity R0 = company unlevered cost of capital Rd = rquired rate of return on debt
Thus, capital structure is irrelevant.
Explain the Modigliani-Miller (MM) proposition Number 2 (With Taxes): WACC is Minimized at 100% Debt
Which are the assumptions of this proposition?
If we assume the marginal tax rate is not zero and then use the WACC formula to solve for return on equity, we get MM Proposition II (with taxes):
Re = R0 +D/E(R0-Rd)(1-t)
R0 = company unlevered cost of capital
The tax shield provided by debt causes the WACC to decline as leverage increases. The value of the firm is maximized at the point where the WACC is minimized, which is 100% debt.
Explain Costs and Potential Effect on the capital structure.
1) Costs of Financial Distress: are the increased costs a company faces when earnings decline and the firm has trouble paying its fixed financing costs (i.e. interests on debt). The financial distress have two components:
a) Costs of financial distress and bankruptcy (direct costs such legal fees and indirect such foregone opportunities)
b) Probability of financial distress
2) Agency Costs of Equity: refer to the costs associated with the conflicts of interest between managers and owners. Managers who do not have a stake in the company do not bear the costs associated with excessive compensation or taking on too much or little risk. Because shareholders are aware of this conflict, they will take steps to minimize these costs, and the net result is called Net Agency Cost of Equity. Net agency costs of equity have three components:
a) Monitoring costs, associated with supervising management, making reports,…
b) Bonding costs: to assure that the managers are working in the shareholder’s best interest, premiums for insurance to guarantee performance, non-compete argreements,…
c) Residual losses: may occur even with adequate monitoring and bonding provisions
ACCORDING TO AGENCY THEORY, the use of debt forces managers to be disciplined with regard to how they spend cash because they have less free cash flow to use for their own benefit. It follows that greater amounts of financial leverage tend to reduce agency costs.
3) Costs of Asymetric Information: refer to costs resulting from the fact that managers typically have more information about a company’s prospects and future performance that owners or creditors. Because shareholders and creditors are aware that the asymetric information problems exist, these investors will look for management behavior that ‘signals’ what knowledge management may have.
- Taking on the commitment to make fixed interest payments through debt send a signal that management has confidence in the firm’s ability to make these payments in the future.
- Issuing equity is typically viewed as a negative signal that managers believe a firm’s stock is overvalued.
The cost of asymetric information increases as the proportion of equity in the capital structure increases.
Explain Peck Order Theory.
Based on asymetric information, is related to the signals management sends to investors through its financing choices. According to pecking order theory, managers prefer to make financing choices that are least likely to send signals to investors. Financing choices under pecking order theory follow a hierarchy based on visibility to investors. In order from most favored to least favored:
1) Internally generated equity (i.e. retained earnings)
2) Debt
3) External equity (i.e. newly issued shares)
Explain Static Trade-Off Theory.
The static trade-off theory seeks to balance the costs of financial distress with the tax shield benefits from using debt. Under the static trade-off theory, there is an optimal capital structure that has an optimal proportion of debt.
If we remove the assumption that there are no costs of financial distress, there comes a point where the additional value added from the debt tax shield is exceeded by the value-reducing costs of financial distress from additional borrowing. This point represents the optimal capital structure for a firm where the WACC is minimized.
Accounting for the costs of financial distress, the expresion for the value of a levered firm becomes:
VL = VU + (t*D) - PV(costs of financial distress)
Why the firm’s actual capital structure tends to fluctuate arounds the target capital structure?
For two reasons:
1) Management may choose to exploit opportunities in a specific financing source. For example, a temporary rise in the firm’s stock price may create a good opportunitu to issue additional equity.
2) Market value fluctuations will occur. Because capital structure weights are determined by market values, market fluctuations may cause the firm’s actual capital structure to vary from the target.
Which country-specific factor related to Institutional an Legal Factors made Use of Total Debt LOWER?
1) Strong legal system
2) Less informational asymetry
3) Favorable tax rates on dividends
4) Common law as opposed to civil law
Which country-specific factor related to Institutional an Legal Factors made Maturity of Debt LONGER?
1) Strong legal system
2) Less informational asymetry
3) Common law as opposed to civil law
Which country-specific factor related to Financial Market Factors made Use of Total Debt LOWER?
1) Little reliance on banking system
2) Greater institutional investor presence
Which country-specific factor related to Financial Market Factors made Maturity of Debt LONGER?
1) More liquid stock and bond markets
2) Greater institutional investor presence
Which country-specific factor related to Macroeconomic Factors made Use of Total Debt LOWER?
1) Higher inflation
2) Higher GDP growth
Which country-specific factor related to Macroeconomic Factors made Maturity of Debt LONGER?
1) Lower inflation
2) Higher GDP growth
If the company follow the static trade-off approach, which capital structure is most likely to choose?
The static trade-off theory seeks to balance the costs of financial distress with the tax benefits provided by debt and states that there is some optimal capital structure with an optimal proportion of debt. The 50% debt, 50% equity choice is most likely to provide this balance.
Give an example of expected cost of financial distress and of bonding cost associated with net agency cost of equity.
Legal and administrative fees associated with bankruptcy and loss of trust from customers are examples of direct and indirect costs associated with expected costs of financial distress.
Cost of insurance premiums to guarantee management performance is an example of a bonding cost associated with the net agency cost of equity.
