Capital Structure

Question 1

What is the market value of a firm?

Answer 1

Market Value = Debt + Equity

Question 2

Is capital structure related to the value of the firm?

Answer 2

Modigliani and Miller Proposition I (MM) (1958) show that in perfect capital markets, capital structure decisions are irrelevant. (They aren’t related)

Question 3

What are MM’s assumptions for a firm paying no taxes?

Answer 3

1. Perfect Capital Markets
2. No arbitrage opportunities
3. WACC is constant and cannot be minimised, regardless of capital structure

Question 4

What is a perfect capital market?

Answer 4

• No taxation
• No bankruptcy costs
• No agency/info problem

Question 5

Why is it not beneficial to have debt in the capital structure?

Answer 5

When a firm adds debt to its capital structure, the remaining equity becomes more risky - hence the cost of equity increases

Question 6

Why does cost of equity increase?

Answer 6

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.

Question 7

What is the cost of equity capital for an all-equity firm?

Answer 7

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

Question 8

Why doesn’t WACC reduce by substituting debt for equity?

Answer 8

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

Question 9

What is the Weighted Average Cost of Capital?

Answer 9

It is the weighting of cost of equity and cost of debt in a firms capital structure

Question 10

Does a levered or all-equity firm pay more in tax?

Answer 10

The all-equity firm will

Question 11

Should a firm choose high-leverage or no leverage in a market with taxes?

Answer 11

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

Question 12

Why should a firm choose 100% debt financing if there are corporate taxes?

Answer 12

This is due to the deductibility of debt’s interest payments from taxation.

Question 13

What is the value of the levered firm?

Answer 13

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

Question 14

What is the value of the unlevered firm?

Answer 14

V(U) = EBIT * (1-T(C))

where

EBIT is earnings before interest and tax

Question 15

What is the present value of the tax shield given perpetual cash flows?

Answer 15

R(D)DT(C)/R(D) or D*T(C)

Question 16

What is the present value of an unlevered firm?

Answer 16

EBIT(1-T(C))/R(A)

Question 17

What is the MM proposition II with corporate taxes? (formula)

Answer 17

R(E) = R(A) + D/E * [R(A)-R(D)] * [1-T(C)]

Question 18

What is WACC with corporate taxes?

Answer 18

WACC = (E/E+D)R(E) + (D/D+E)R(D)*(1-T(C))

Question 19

Does WACC decline with leverage?

Answer 19

In a world with corporate taxes, WACC declines with leverage. In the case of no tax, WACC is unaffected by leverage

Question 20

What are the disadvantages to debt?

Answer 20

-Creditors can force the firm into bankruptcy

–because interest and principle payments are legal obligation

Question 21

What are the direct costs of bankruptcy?

Answer 21

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

Question 22

What are the indirect costs of bankruptcy?

Answer 22

• 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.)

Question 23

How can shareholders help themselves if there are agency costs?

Answer 23

• Taking large risks
• Underinvestment
• Milk the property

Question 23

How can shareholders help themselves if there are agency costs?

Answer 23

• Taking large risks
• Underinvestment
• Milk the property

Question 24

What is the Optimal Capital Structure by trading off tax benefits and bankruptcy costs?

Answer 24

V(L) = V(U) + [tax benefits - bankruptcy costs]

Question 25

What is the Optimal Capital Structure by trading off tax benefits and agency costs?

Answer 25

V(L) = V(U) + [tax benefits - agency costs]

Question 26

What happens to the value of the actual firm as debt increases?

Answer 26

The value of the firm will first rise until a certain point, where tax benefits are offset by rising distress costs due to additional borrowing.

The ‘turning point’ is known as ‘optimal debt’

Question 27

What happens to WACC as debt increases?

Answer 27

WACC will initially decrease due to the tax shield, but rises beyond the optimal debt point due to financial distress

Question 28

When was Pecking Order theory created?

Answer 28

In 1984 by Myers and Majluf

Question 29

What is the basis of pecking order theory?

Answer 29

Managers know more than outside investors about the prospects of a firm (asymmetric info)

If debt is not riskless then firms may not always benefit from a positive NPV project

Question 30

What is the safest source of financing?

Answer 30

Internal Finance (retained earnings)

Question 31

What is the riskiest source of financing?

Answer 31

Risky Equity

Question 32

What are the rules of the pecking order?

Answer 32

• 1st use internal financing where possible
• 2nd issue debt for the tax shield benefits
• 3rd issue equity as a last resort

Question 33

Summary

Answer 33

➢Modigliani-Miller’s Propositions I & II (No Taxes): Proposition I: Market value of a firm is independent of its capital structure. Proposition II: WACC should remain constant.

➢Modigliani-Miller’s Propositions I & II (Corporate Taxes): Proposition I: Tax shield from debt increases the firm value. Proposition II: WACC declines because of the tax shield from debt.

➢Capital Structure and Bankruptcy: Don’t use too much debt.

➢Capital Structure and Agency Costs : Taking large risks, Underinvestment, Milking the property

➢Trade-off Theory

➢Pecking Order Theory

➢Theoretical and Empirical Evidence

Question 34

What does the MM proposition I (1958) relate to?

Answer 34

Firm Value is independent of capital structure

Question 35

What does the MM proposition II (1958) relate to?

Answer 35

WACC should remain constant

Question 36

What does the MM proposition I (1963) relate to?

Answer 36

Tax shield from debt increases firm value

Question 37

What does the MM proposition II (1963) relate to?

Answer 37

WACC declines because of the tax shield from debt