Capital Structure

Question 1

State 5 capital Structure theories

Answer 1

• Modigliani and Miller’s (MM) propositions. - Capital structure with tax considerations: MM’s propositions with corporate taxes. The Miller model with both corporate and personal taxes. Non-debt tax shields.
• Financial distress costs and the trade-off theory.
• Asymmetric information and the pecking order theory.
• Other views of capital structure (e.g., market timing).

Question 2

What is Modiglian and miller proposition 1

Answer 2

The total value of a firm is equal to the market value of the total cash flows generated by its assets, and is NOT affected by its choice of capital structure.

Question 3

Assumptions of MM’s Irrelevance propositions

Answer 3

Perfect capital markets without frictions: No taxes, transaction costs and issuance costs.
No agency problems and asymmetric information.
Investors and firms can borrow and lend at the same rate.
Financing decisions do not change the cash flows generated by investments.
No arbitrage

Question 4

MM’s Proposition II

Answer 4

The cost of equity of a levered
firm increases in proportion to the debt-equity ratio (D/E), expressed in market value terms.

Question 5

Determinants of Capital structure

Answer 5

Firm size, Tangibility, Profitability, Growth opportunities, Industry capital structure, Taxes, Non-debt tax shields

Question 6

MM’s (1963) ‘corrected’ Proposition III

Answer 6

Firm value = All-equity Financed Value + PV(DITS)

VL = VU + Tc*D

Question 7

Assumptions when estimating T*

Answer 7

Interest deductibility is limited by the availability of
positive taxable earnings.
Assumptions when estimating T*:
Investors pay capital gains taxes every year.
Certain tax rates on dividends and capital gains.
However, tax rates vary for individual investors while many
investors face no personal taxes

Question 8

Which Valution method should be used :
Value a project financed with all equity
Value a project financed with constant leverage
Value a project financed with a fixed level of debt
Value a project with predetermined debt repayments

Answer 8

WACC
WACC
APV
APV

Question 9

arbitrage in MM model

Answer 9

The existence of an arbitrage opportunity violates the assumption of the MM model. In perfect capital markets, such an opportunity should not exist.
Adjustments will quickly eliminate any arbitrate opportunities and achieve an equilibrium.

Question 10

implications of MM’s proposition 2

Answer 10

Misconception: increasing the amount of debt reduces the WACC because debt has a lower cost than equity.

MM showed that “any attempt to raise the value of the firm by issuing debt will be exactly offset by the increase in the cost of capital”.

Question 11

MM’s propositions do not hold in the real world, what is the importance of them

Answer 11

The approach that MM took to derive them. If capital structure matters, it must stem from market imperfections or frictions (e.g., taxes, agency problems, asymmetric information).
MM’s ideas marked the beginning of the modern theory of corporate finance

Question 12

Summary of MM’s propositions

Answer 12

MM’s (1958) Propositions I and II: capital structure does NOT matter.
MM’s (1963) Proposition III: capital structure is relevant with corporate taxes.
Profitable firms should use more debt. Firms with sufficient EBIT should be 100% debt financed.
These implications are extreme.
Issues to be considered: Personal taxes, Financial distress costs, Agency costs of debt.

Question 13

Direct costs of Bankruptcy

Answer 13

Incurred to facilitate an orderly bankruptcy process (takes 2 years)
Mainly include costly professional fees (e.g., legal and accounting fees).
Average direct bankruptcy costs represent 4-17% of the pre-bankruptcy firm market value
Costs are higher for firms with more complicated operations or large number of creditors.
Relatively higher for small firms

Question 14

examples of indirect costs of financial distress

Answer 14

Indirect costs are incurred due to the potential:
Loss of customers, loss of suppliers, loss of employees, loss of receivables, fire sales of assets, and delayed liquidation.

Question 15

briefly describe the lemons problem

Answer 15

At a price based on average quality, high-quality sellers
have little or no incentive to sell their goods

Question 16

Consider a financial market where firms wish to issue
new shares with Two types of firms: ‘good quality’ vs. ‘bad quality’.

explain adverse selection

Answer 16

The owners/managers of the securities know the true
value of the firms but the investors don’t, i.e., asymmetric
information.

Assumption: the investors believe that each security has
50% chance of being either ‘good’ or ‘bad’

However, this expected price is not an equilibrium price as ‘Bad’ firms are over-valued and ‘good’ firms are under-valued.

Question 17

consequences of adverse selection

Answer 17

• both the quality and prices of equity issues are low

Stock market undervalues the equity of high-quality firms and
overvalues that of low-quality firms.
Investors will only be willing to pay a low price for the equity issued. High-quality firms have no incentive to issue equity, while only
low-quality firms have incentives to issue equity.
Further consequences: Underinvestment, The Pecking order of corporate financing

Question 18

Pecking order theory model setup

Answer 18

Main assumption: asymmetric information exists such
that uninformed investors do not know a firm’s “type”.
Firm quality is characterised by: assets, ai and investment
opportunities, bi (bi >0) (i=L, H).
Probabilities of high and low quality: pH and pL where pL
= (1−pH).
Other variables: internal funds, S (slack), and investment
outlay, I. Assume S < I.
New external equity, E=I –S (assume no debt)

Question 19

How does POT effect capital structure decisions

Answer 19

Firms prefer internal funds to external finance.
If external finance is required, firms prefer issuing “safer” claims that are least sensitive to mispricing (or undervaluation).

Question 20

Pecking order of financing:

Answer 20

(1) internal equity or riskless debt;
(2) risky debt;
(3) debt-equity hybrids (convertibles and preferred stock);
(4) external equity (last resort).

Question 21

Predictions of the POT

Answer 21

Firms have no well-defined optimal capital structures.
Highly-profitable firms will issue little debt, i.e., a negative relation between profitability and leverage.
Capital expenditures are mainly financed through
internally generated cash flows.
Equity is considered ‘a last resort’