2.1 Capital Structure

Question 1

Define discount rate(s)

Answer 1

Opportunity cost of capital required by investors given the best available expected return offered on investments of comparable risk and timing.

Question 2

What is Discounted Flow Valuation?

Answer 2

Universal method the applies to the valuation of any asset or security.

Discount rate not the same across all classes of claims as it always reflects the riskiness of the cash flows at hand.

Question 3

Discounted Cash Flow Valuation equation

Answer 3

General case of uncertainty combined with a non-flat term structure.

When PV becomes a nice sigma sum function: consistency in the discount rate.

Question 4

If there is no fixed schedule of mandatory payments (like debt), a firm may choose never to pay dividends. Is equity therefore costless?

Answer 4

No. Shareholders require their opportunity cost of capital, i.e. return of next-best alternative of the same risk.

Question 5

What are sources of value?

Answer 5

Dividends, as well as price increases.

Question 6

How can managers estimate cost of equity?

Answer 6

Question 7

Equilibrium in capital structure

Answer 7

Absent arbitrage opportunities.

Stock price revels the correct opportunity cost of the firm’s equity.

Question 8

Difference between equity and debt

Answer 8

Equity:

Residual claim (cash flows subject to availability)

Cost of equity = return on comparable investment

Debt:

Fixed claim (repayments known in advance)

Debt is senior to equity

No default risk: cost of debt = return on riskless securities.

Question 9

Merton’s (1974) model

Assumptions and implications

Answer 9

Assumes that: all firm debt is a zero bond with face value d and maturing in T.

Graph shows payoffs to debt- and equity holders in T as a function of firm value V.

The upside potential to the debt is capped at d while unlimited for the stock.

Question 10

Observations about debt and equity financing

Answer 10

Risk-free or not, debt remains generally less risky than equity since creditors are paid first.

Equity financing more expensive than debt financing.

Question 11

When does distinguishing between debt and equity financing actually matter?

Answer 11

Distinction between debt and equity only relevant if future cash flows from business operations are uncertain.

Otherwise, with certain expectations (Fisher Model), both types of claimants could forecast cash flows accurately and would require the risk-free rate.

Question 12

Aim of capital structures

Answer 12

Can the financial manager maximise firm value by finding the optimal financing mix? (The capital structure that minimises the average cost of capital)

Question 13

How will the capital structure determine firm value?

Answer 13

Mix of equity and debt will affect the discount rate which discount future cashflows.

Thus it will affect firm value.

Question 14

What is the Weighted Average Cost of Capital (WACC)?

Answer 14

A metric which reflects the relative proportions of equity and debt in this capital structure.

Question 15

Equation for WACC

Answer 15

Question 16

How can we calculate the firm’s market value?

+ equation

Answer 16

Firm’s market value = sum of its outstanding debt and common stock market values, as well as to the present value of the relevant future cash flows discounted by the WACC.

Question 17

Example:

Table for rate of reurns for both scenaries and whole venture for equity and debt combinations 100:0, 75:25, 50:50. 25:75: 10:90.

Answer 17

Question 18

Example:

What observations can be made?

Answer 18

Spread between returns in both states of the world widens with debt share. Standard deviation of return increases and equity becomes riskier.

Expected return (or cost of capital) of the equity increases.

Question 19

How can we write r_E when r_D is riskless?

Answer 19

Question 20

Impact of a higher leverage on WACC

Answer 20

Question 21

Traditional view: diagram for debt/equity ratio

Answer 21

Question 22

Implications of the traditional view

Answer 22

Moderate borrowing → rather flat increase in r_E, whereas the rate shoots up when borrowing excessively.

Curve for the weighted average capital cost r_A is convex - minimum at (D=E) = optimal capital structure.

Question 23

Traditional view: three effects of growing debt

Implication of these effects

Answer 23

1. “Expensive” equity substituted by “cheap” debt.
2. Equity becomes more “risky”, return required by shareholders increases (initially slow but then accelerates).
3. Debt cost increases - high leverage - when creditors begin to think their position is not secure anymore.

Opposing effects: there is an optimal capital structure where both effects exactly cancel out. Below optimum (1) is more important than (2).

Question 24

Modigliani-Miller proposition I

Answer 24

Question 25

What does the “pie theory” state?

Answer 25

“The size (value) of the pie (firm) is independent of hot it is divided. It does not matte how it is divided up between different claimants (debt- and shareholders).”

Question 26

How does cost of equity r_E (λ) need to adjust for equilibrium (V_U = V_L) to hold?

Answer 26

Then: Modigliani-Miller proposition II

Question 27

Modigliani-Miller propostition II

Answer 27

Question 28

Modigliani-Miller returns graphically

Answer 28

Question 29

Modigliani-Miller conclusions

Answer 29

Perfect capital market in equilibrium: capital structure decisions irrelevant as they cannot create any value.

Two firms entirely identical except for their leverage must have same value.

Question 30

Why must entirely identical firms except for their leverage have the same value?

[M-M conclusion]

Answer 30

Investors can use perfect and complete capital market to transform an existing cashflow stream into one that fits their risk preferences without any loss (same argument as Shareholder Unanimity conclusion in the Fisher model).

Cost of equity increases in the leverage ratio. However, higher returns entail higher risks.

Question 31

Modigliani-Miller conclusions for valuation

Answer 31

eEmployed discount rate should be r_A= r_E(0) if the cashflows “to the firm”. r_E(λ) is the cashflows “to the equity” only.

Question 32

What is the modern view with frictions?

Answer 32

Relax Modigliani-Miller assumptions and introduce two sources of frictions: taxes and brankruptcy.

Question 33

What if we introduce taxes?

Recognition and intuition

Answer 33

Recognition: debt interest can be deducted from taxable income.

Intuition: Government effectively pays fraction of the interest. Investors cannot get such a tax break on homemade leverage. Hence, they will pay a premium for levered firms.

Question 34

What happens to WACC after-tax? Implication?

Answer 34

WACC decreases as leverage increases.

Firm value is maximised when the firm is entirely debt-financed and no shares are issued.

Question 35

What if we introduce financial distress and bankruptcy?

Answer 35

Question 36

What constitutes direct costs?

[financial distress]

Answer 36

Administrative and court cost, legal and advisory fees.

^ Resources spent by management and creditors dealing with bankruptcy.

Mismanagement by judges (blocking/delaying non-routine expenditures.

US average time in bankruptcy: 20 months

Question 37

What conclusions can be taken from introducing financial distress into the modern view?

Answer 37

Tax benefit counterbalanced to some extent by “dark side of debt”, costs of financial distress, and there is effectively an optimal level of leverage.

Interplay of the two factors is called the “trade-off theory” of debt.

Question 38

Diagram with frictions: trade-off theory

Answer 38

Question 39

What does Modigliani-Miller’s ideas imply about dividend policy?

Answer 39

Irrelevance of the dividend policy.

Question 40

Why is the dividend policy independent of consumption preferences of the shareholders?

Recall: Fisher Model.

If firm invests in all positive-NPV and reduces $c_0$ consumption (cuts dividends) and the resulting time of payments (dividend amounts) is not in line with shareholders’ consumption preferences, they can sell part or all of their stock in capital market, thereby achieving favoured consumption plan.

Answer 40

Recall: Fisher Model.

• If firm invests in all positive-NPV and reduces c₀ consumption (cuts dividends) and the resulting time of payments (dividend amounts) is not in line with shareholders’ consumption preferences, they can sell part or all of their stock in capital market, thereby achieving favoured consumption plan.

Question 41

Why is the dividend policy independent of the firm’s investment decisions?

Answer 41

In perfect capital market: effect of an investment project on market value is independent of the source of financing.

Dividend payout costs as much as its replacement if the firm was to raise cash. Since capital market allows firms to substitute the dividends paid out through borrowing, positive-NPV investment projects can still be pursued.

Hence, dividend policy is independent.

Question 42

How can dividend irrelevance proposition be reconciled with the DDM?

Answer 42

Recall: DDM with growth, present value can be increased by retaining more cash (i.e. paying less dividends) when firm has access to growth opportunities.

MM: Given firm’s investment program, no value can be added by tinkering with the payouts. Same for the shareholders.

Question 43

Does dividend irrelevance contradict MM?

Answer 43

In the DDM, effects from investment policy and dividend policy are confounded. When we increase b (because of good reinvestment opportunities with ROE>r), the dividend ratio is reduced AND an investment decision is made, both at the same time. The implied positive-NPV investment explains the value increase, NOT the financing decision of cutting back dividends.

Hence, it’s not in contradiction to MM.

Question 44

Payout policy can matter in the real world. What are important market imperfections to consider?

Answer 44

Taxes, transaction costs, information asymmetry

Question 45

Tax as a market imperfection: effect on dividend policy

Answer 45

If tax rate on dividends is higher than the one on capital gains, investors are drawn to low-payout stocks.

Question 46

Transaction costs as a market imperfection: effect on dividend policy

Answer 46

Dividend policy varies over firm’s life cycle (cheaper to retain cash if it is needed than to raise new capital). Younger companies tend to retain more cash for growth, whereas mature firms pay out.

Question 47

Information asymmetry as a market imperfection: effect on dividend policy

Answer 47

When managers have better information than investors on firm’s future prospects, payout decisions may signal this information.