[6] Debt

Question 1

Capital Structrue Def

Answer 1

a firm’s mix of debt and equity financing.

Question 2

Financial Leverage Def

Answer 2

the use of debt, as an attempt to increase the returns to equity.

Question 3

Explain the use of leverage to increase stock returns

Answer 3

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)

Question 4

The value of the firm is unaffected by…

Assumes What?

Answer 4

… its choice of capital structure

Perfect Market

Question 5

in efficient markets, the absence of ____ _____ means that strategies have the same return
and thus should have the same _____ / _____

Answer 5

abitrage oppotunities

cost / price

Question 6

What is MM’s first proposition?

Answer 6

The market value of any firm is independent of its capital structure.

Question 7

Firm value and, therefore, shareholders’ wealth is not determined by its ____ ______.
Firm value is determined on the left-hand side of the ____ ____, by ____ _____.

Answer 7

Capital Structure
balance sheet
real assets

Question 8

MM stands for

Answer 8

Modigliani and Miller

Question 9

MM’s Assumptions (5)

Answer 9

Competitive Markets
Effienct Markets
Absence of tax
Absence of bunkruptcy costs
Investment oppotunities unaffected by financing decisions

Question 10

Competitive market assumption implications x1

Answer 10

individuals can borrow and lend at the same rate; individuals can borrow at the same interest rate as firms.

Question 11

Efficient Market assumption

meaning x1, implication x1

Answer 11

complete and symmetric info

so no arbitrage oppotunities

Question 12

Absence of Tax: in reality ____ payments are ____ _____ (contrary to _____). Levered firms can ____ overall ____ obligations (advantages on leverage)

Answer 12

interest
Tax deductible
Dividends
Reduce tax

Question 13

Therefore, can say effect of leverage depends on company’s ___ ____
Change in capital structure has changed ____ ___ ___ and returns on ____.

Answer 13

expected income

EPS, shares

Question 14

UNLEVERED FIRM:
Operating income =

Return on shares =

Earnings per share =

Answer 14

=Equity earnings

=Operating income / market value OR EPS/Price

=Operating income / No. of shares

Question 15

LEVERED FIRM:

Interest =

Equity earnings =

Earnings per share =

Returns on shares =

Answer 15

interest rate x value of debt

= operating income - interest

= equity earnings / no. of shares

= equity earnings /market value of shares OR EPS / prices

Question 16

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 ___.

Answer 16

cost the same
Operating incomes
equity
assets

Question 17

leverage increases the stream of expected
____ ___ ___ but not the __ ___.

Reason for this ?

Answer 17

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.

Question 18

Formula for the expected return on the company’s assets [2 variables]

What is notation for this?

Answer 18

rA = expected operating income / market value of all securities

Question 19

Why does the borrowing decision not affect the expddcted return on the company’s assets?

Answer 19

As company’s borrowing decision does not affect either the firm’s operating income or the total market value of its securities.

Question 20

Formula for the expected return on a portfolio consisting of all the firm’s securities?

What is this known as?

Answer 20

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

Question 21

what is MM’s second proposition?

What does it depend on?

Answer 21

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 ).

Question 22

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

Answer 22

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.

Question 23

When the firm is levered, they require a ___ of (𝑟𝐴−𝑟𝐷) 𝐷/𝐸 to ____ for the extra ____

Answer 23

premium
compensate
risk

Question 24

can shareholders be indifferent to increased leverage when it increases expected return?

Answer 24

: any increase in expected return is exactly offset by an increase in risk and, therefore, in shareholders’ required rate of return.

Question 25

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 ____ ___ _____ ____

Answer 25

risk
oppotunity cost of capital
weighted-average cost of capital

Question 26

Does capital structure affect individual securities?

Answer 26

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.

Question 27

Suppose that the company decided instead to repay all its debt and to replace it with equity. What would happen to rA and rE ?

Answer 27

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%.

Question 28

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 ___ ___.

Answer 28

linearly
risk-free
leverage
higher retur on debt
Expected return on equity 
slow down

Question 29

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.

Answer 29

risk of defualt
higher rates of interst
rate of increase 
slows down
debt
less

Question 30

Why does the slope of the rE line decreases as D/E increases? x2

Answer 30

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

Question 31

Whats the issue with ignoring tax assumption?
Thus?

What does this change?

Answer 31

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)

Question 32

Debt creates a ___ ___ for levered firms because it reduces ___ ____

Answer 32

tax shield

taxable income

Question 33

What is formula for tax deduction?

Answer 33

Tax shield = interest payment x Corporate tax rate

= D x rD x Tc

Question 34

What is the Formula for Expected Return on Equity?

Answer 34

𝑟𝐸 = 𝑟𝐴+(𝑟𝐴−𝑟) * 𝐷/𝐸