Capital Structure Flashcards
What is the market value of a firm?
Market Value = Debt + Equity
Is capital structure related to the value of the firm?
Modigliani and Miller Proposition I (MM) (1958) show that in perfect capital markets, capital structure decisions are irrelevant. (They aren’t related)
What are MM’s assumptions for a firm paying no taxes?
- Perfect Capital Markets
- No arbitrage opportunities
- WACC is constant and cannot be minimised, regardless of capital structure
What is a perfect capital market?
- No taxation
- No bankruptcy costs
- No agency/info problem
Why is it not beneficial to have debt in the capital structure?
When a firm adds debt to its capital structure, the remaining equity becomes more risky - hence the cost of equity increases
Why does cost of equity increase?
Because debt has a prior claim on a firms’ assets and earnings, the risk to equity holders increases. They must therefore be compensated a higher rate of return.
What is the cost of equity capital for an all-equity firm?
R(E) = R(A) + (D/E)*(R(A)-R(D))
where:
R(E) is the cost of equity capital
R(A) is the WACC for an all-equity firm
R(D) is the cost of debt
D/E is the debt-equity ratio
Why doesn’t WACC reduce by substituting debt for equity?
This is because a higher D/E ratio means a higher R(E). This higher R(E) exactly offsets the weighting change between equity and debt in WACC
What is the Weighted Average Cost of Capital?
It is the weighting of cost of equity and cost of debt in a firms capital structure
Does a levered or all-equity firm pay more in tax?
The all-equity firm will
Should a firm choose high-leverage or no leverage in a market with taxes?
The firm should choose high-leverage as the sum of equity plus debt is greater than the equity of the unlevered firm. Ideally it would be 100% debt financed
Why should a firm choose 100% debt financing if there are corporate taxes?
This is due to the deductibility of debt’s interest payments from taxation.
What is the value of the levered firm?
V(L) = V(U) + R(D)DT(C)
where:
V(L) is the value of the levered firm
V(U) is the value of the unlevered firm
R(D) is the cost of debt
D is the value of the debt
T(C) is the corporation tax rate
What is the value of the unlevered firm?
V(U) = EBIT * (1-T(C))
where
EBIT is earnings before interest and tax
What is the present value of the tax shield given perpetual cash flows?
R(D)DT(C)/R(D) or D*T(C)
What is the present value of an unlevered firm?
EBIT(1-T(C))/R(A)
What is the MM proposition II with corporate taxes? (formula)
R(E) = R(A) + D/E * [R(A)-R(D)] * [1-T(C)]
What is WACC with corporate taxes?
WACC = (E/E+D)R(E) + (D/D+E)R(D)*(1-T(C))
Does WACC decline with leverage?
In a world with corporate taxes, WACC declines with leverage. In the case of no tax, WACC is unaffected by leverage
What are the disadvantages to debt?
-Creditors can force the firm into bankruptcy
–because interest and principle payments are legal obligation
What are the direct costs of bankruptcy?
The legal and administrative costs. For example, fees paid to lawyers, administrators, accountants, etc.
Lehamn Brother’s paid $1.05bn within 2 years of bankruptcy
What are the indirect costs of bankruptcy?
- Lost sales due to suppliers and customers not trusting quality and integrity
- Increases the cost of doing business (harder to get credit, loss of staff etc.)
How can shareholders help themselves if there are agency costs?
- Taking large risks
- Underinvestment
- Milk the property
How can shareholders help themselves if there are agency costs?
- Taking large risks
- Underinvestment
- Milk the property
