[6] Debt Flashcards
Capital Structrue Def
a firm’s mix of debt and equity financing.
Financial Leverage Def
the use of debt, as an attempt to increase the returns to equity.
Explain the use of leverage to increase stock returns
the firm borrows and invests in assets that have a rate of return greater than the interest on the loan (effectively, +NPV)
real value of the firm increases (& value of equity as well)
The value of the firm is unaffected by…
Assumes What?
… its choice of capital structure
Perfect Market
in efficient markets, the absence of ____ _____ means that strategies have the same return
and thus should have the same _____ / _____
abitrage oppotunities
cost / price
What is MM’s first proposition?
The market value of any firm is independent of its capital structure.
Firm value and, therefore, shareholders’ wealth is not determined by its ____ ______.
Firm value is determined on the left-hand side of the ____ ____, by ____ _____.
Capital Structure
balance sheet
real assets
MM stands for
Modigliani and Miller
MM’s Assumptions (5)
Competitive Markets Effienct Markets Absence of tax Absence of bunkruptcy costs Investment oppotunities unaffected by financing decisions
Competitive market assumption implications x1
individuals can borrow and lend at the same rate; individuals can borrow at the same interest rate as firms.
Efficient Market assumption
meaning x1, implication x1
complete and symmetric info
so no arbitrage oppotunities
Absence of Tax: in reality ____ payments are ____ _____ (contrary to _____). Levered firms can ____ overall ____ obligations (advantages on leverage)
interest
Tax deductible
Dividends
Reduce tax
Therefore, can say effect of leverage depends on company’s ___ ____
Change in capital structure has changed ____ ___ ___ and returns on ____.
expected income
EPS, shares
UNLEVERED FIRM:
Operating income =
Return on shares =
Earnings per share =
=Equity earnings
=Operating income / market value OR EPS/Price
=Operating income / No. of shares
LEVERED FIRM:
Interest =
Equity earnings =
Earnings per share =
Returns on shares =
interest rate x value of debt
= operating income - interest
= equity earnings / no. of shares
= equity earnings /market value of shares OR EPS / prices
The share of the company under leverage must ___ ___ ____as the share of the company with no leverage (given, of course, identical ___ ____).
What changes is the relative return on ___ , not the overall return on ___.
cost the same
Operating incomes
equity
assets
leverage increases the stream of expected
____ ___ ___ but not the __ ___.
Reason for this ?
Earnings per share
share price
the change in the expected earnings stream is exactly offset by a change in the rate at which the earnings are discounted.
Formula for the expected return on the company’s assets [2 variables]
What is notation for this?
rA = expected operating income / market value of all securities
Why does the borrowing decision not affect the expddcted return on the company’s assets?
As company’s borrowing decision does not affect either the firm’s operating income or the total market value of its securities.
Formula for the expected return on a portfolio consisting of all the firm’s securities?
What is this known as?
rA = [E/A] x rE + [D/A] x rD
WACC ; the weighted average cost of capital
rE: expected return on Equity
E/A: proportion of Equity
D/A: proportion of Debt
rD: expected return on Debt
what is MM’s second proposition?
What does it depend on?
The expected rate of return on the common stock of a levered firm increases in proportion to the market value of the debt-equity ratio (D/E ).
THUS The rate of increase depends on the spread between the expected return on all the firm’s securities/assets (rA) and the return on debt (rD ).
Implicationsof MM’s second proposition?
1: x2 What matters and what is irrelevant?
2: x2 Leverage only creates what type of spread? Between?
What does expected return on Equity [rE] equal when Debt =0?
and what does this mean for rA and rE if Debt > 0
What matters is the operating income (or cash flows) and the overall market value of our financial assets.
The composition of our financial assets (i.e., the capital structure) is irrelevant.
Implication 2:
Leverage only creates a positive spread between the expected return on equity (or common stock) and the (weighted) expected return of financial assets.
Remember: 𝑟𝐸 = 𝑟𝐴+(𝑟𝐴−𝑟) * 𝐷/𝐸
notice that when D =0, then rE = rA;
as long as D >0 , then rE > rA;
it is not rA that has changed, but… only rE has increased.
When the firm is levered, they require a ___ of (𝑟𝐴−𝑟𝐷) 𝐷/𝐸 to ____ for the extra ____
premium
compensate
risk
can shareholders be indifferent to increased leverage when it increases expected return?
: any increase in expected return is exactly offset by an increase in risk and, therefore, in shareholders’ required rate of return.
If the firm is to invest in a project that has the same ___ as the firm’s existing business, the ___ ___ ___ ___ for this project is the same as the firm’s ____ ___ _____ ____
risk
oppotunity cost of capital
weighted-average cost of capital
Does capital structure affect individual securities?
Although the required return on the portfolio of debt and equity is unaffected, the change in financial structure does affect the required return on the individual securities.
Leverage affects the calculation of the cost of capital, because it affects the information in equity and debt returns.
Suppose that the company decided instead to repay all its debt and to replace it with equity. What would happen to rA and rE ?
A5: In that case all the cash flows would go to the equity holders. The company cost of capital, rA, would stay at 9%, and rE would also be 9%.
GRAPHICAL:
The expected return on equity increases ___ with the
debt-equity so long as debt is ___-___.
But if ____ increases the debt risk, debtholders
demand a ___ ___ on ___.
This causes the rate of increase in ___ ___ ____ ___ to ___ ___.
linearly risk-free leverage higher retur on debt Expected return on equity slow down
As the firm borrows more, the ___ ___ ___ increases and the firm is required to pay ___ ___ ___ ____.
Proposition II predicts that when this occurs the rate of ___in rE ____ ___.
The more ___ the firm has, the ___ sensitive rE is to further borrowing.
risk of defualt higher rates of interst rate of increase slows down debt less
Why does the slope of the rE line decreases as D/E increases? x2
Because holders of risky debt bear some of firm’s financial risk.
As the firm borrows more, more of that risk is transferred from stockholders to bondholders
Whats the issue with ignoring tax assumption?
Thus?
What does this change?
Interest paid on a firm’s debt is deductable from taxable income.
so as debt increases the after-tax WACC falls with a tax shield
This changes WACC formula as after-tax cost of debt is rD(1-Tc)
Debt creates a ___ ___ for levered firms because it reduces ___ ____
tax shield
taxable income
What is formula for tax deduction?
Tax shield = interest payment x Corporate tax rate
= D x rD x Tc
What is the Formula for Expected Return on Equity?
𝑟𝐸 = 𝑟𝐴+(𝑟𝐴−𝑟) * 𝐷/𝐸
