Capital structure

Question 1

Modigliani-Miller Propositions

Answer 1

MM Proposition I without taxes: Capital structure irrelevance

MM Proposition II without taxes: Higher financial leverage raises the cost of equity

MM Proposition I with taxes
MM Proposition II with taxes

Question 2

MM Proposition I without taxes:

Answer 2

“capital structure irrelevance”

• the MV of a firm is not affected by the capital structure
• the MV of a firm is determined solely by its CF

Value of levered firm = value of unleveled firm

Assumptions

• all investors have homogeneous expectations
• perfect capital markets: no transaction costs, taxes, perfect information
• investors can borrow/ lend at RF rt
• managers will act to max shareholder wealth
• financing and investment decisions are independent of each other

Question 3

MM Proposition II without taxes

Answer 3

Higher financial leverage raises the cost of equity

• the MV of the firm is unaffected by changes in DE and the WACC remains constant
• the re increases to exactly offset the increased use of cheaper debt in order to maintain a constant WACC
• ie WACC is determined by the business risk of the firm, not by the capital structure

Question 4

Systematic Risk

Answer 4

• systematic risk or beta of a firm’s assets is a weighted average of systematic risk and its sources of capital
• as the use of debt rises, the risk to equity holders rises, and therefore the equity beta rises

Question 5

Systematic risk formula

Answer 5

=
Ba = (wd * Bd) + (we * Be)

Ba (asset beta) = %debt * beta debt + %equity * beta equity

Be = Ba + (Ba - Bd) * DE

Question 6

MM Proposition I with taxes

Answer 6

• interest paid is tax-deductible; the use of debt provides a tax shield that increases the value of a firm

“The value of a levered firm is equal to the value of an unlevered firm plus the value of the debt tax shield”
- WACC will decline as debt increases because of the tax shield

VL = VU + (t * D)

Question 7

If zimmer corp is financed with 40% debt and 60% equity, the asset beta is 0.7 and the beta of the debt is 0.3, what is the equity beta?

Answer 7

Be = Ba + (Ba - Bd) * DE

Be = 0.7 + (0.7 - 0.3) * 0.4/0.6

Be = .967

Question 8

A tech firm or an airline company would experience more or less financial distress at or in bankruptcy?

Answer 8

A tech firm would experience higher costs of financial distress in bankruptcy

• the costs of financial distress are lower for companies whos assets have a ready secondary market
• airlines, shipping firms.

Question 9

The optimal capital structure is

Answer 9

• is the one at which the value of the company is maximized and the WACC is minimized
  VL = VU + tD

*analysts and mgmt should focus on the TARGET capital structure; typically unknown to analysts
analysts estimate the target structure by one of these methods:
- assuming the firm’s current capital structure is the target
- examine trends in the firm’s capital structure or statements by mgmt to infer
- use averages of comps

it should be calculated using MV of equity and debt
However, book value (BV) is used in practice since
- MV can fluctuate a lot
- mgmt is concerned with the amt and types of capital invested “by” the firm and not “in” the firm
- lenders and rating agencies typically focus on BV

Question 10

Free CF hypothesis

Answer 10

• high debt levels discipline managers by forcing them to make fixed debt service payments and by reducing the company’s free cash flow
• the more levered a firm is, the less freedom managers have to misuse cash
• high leverage reduces agency costs

Question 11

Shareholder theory v stakeholder theory

Answer 11

shareholder theory: the goal of the firm is to maximize shareholder returns
stakeholder theory: the firms focus includes shareholders, customers, employees, suppliers, etc

Question 12

Debt v equity confict

Answer 12

• debt holders will prefer decisions that reduce the leverage and financial risk of a firm
• common shareholders prefer higher leverage that provides greater return potential