CAPITAL STRUCTURE

Question 1

CAPITAL STRUCTURE

Answer 1

• The collection of securities a firm issues to raise capital from investors.
• The relative proportions of debt, equity, and other securities that a firm has outstanding.

Question 2

DEBT TO VALUE RATIO

Answer 2

[D/(E+D)]

Question 3

PERFECT CAPITAL MARKET

Answer 3

A perfect capital market is a market in which:

• Securities are fairly priced.
• No tax consequences or transaction costs.
• Investment cash flows are independent of financing choices.

Question 4

Modigliani and Miller (MM) perfect capital market theory.

Answer 4

• In an unlevered firm, cash flows to equity equal the free cash flows from the firm’s assets.
• In a levered firm, the same cash flows are divided between debt and equity holders.
• The total to all investors equals the free cash flows generated by the firm’s assets.

Question 5

MM Proposition I

Answer 5

In a perfect capital market, the total value of a firm is equal to the market value of the free cash flows generated by its assets and is not affected by its choice of capital structure.

Vl = E + D = Vu

Weighted average cost of capital

rU = (D/(D+E))rD + ((E/(D+E)rE)

Question 6

MM Proposition II

Answer 6

The cost of levered equity.

rE = rU + (D/E)(rU - rD)

Cost of levered equity equals the cost of unlevered equity plus a premium proportional to the debt-equity ratio.

Question 7

What do market imperfections do?

Answer 7

Can create a role for the capital structure.

Question 8

What impact do interest payments have on taxes?

Answer 8

Corporations pay taxes on their profits after interest payments are deducted. Thus, interest expense reduces the amount of corporate taxes:

• Increases amount available to pay investors.
• Increases value of the corporation.

Creates an incentive to use debt.

Question 9

INTEREST TAX SHIELD

Answer 9

The gain to investors from the tax deductibility of interest payments.

interest tax shield = corporate tax rate * interest payments

When a firm uses debt, the interest tax shield provides a corporate tax benefit each year.
To determine the benefit, compute the present value of the stream of future interest tax shields.

(Cash flows to investors with leverage) = (Cash flows to investors without leverage) + (interest tax shield)

The increase in total cash flows paid to investors is the interest tax shield.

Question 10

MM Proposition I with Taxes

Answer 10

The total value of the levered firm exceeds the value of the firm without leverage due to the present value of the tax savings from debt.

VL = VU + PV (Interest Tax Shield)

Question 11

PRESENT VALUE OF INTEREST TAX SHIELD

Answer 11

PV(Interest Tax Shield) = (tc * Interest) / rf
= (tc * (rf *D) / rf
=tc * D

If the debt is fairly priced, no arbitrage implies that its market value must equal the present value of the future interest payments.

Question 12

MARKET VALUE OF DEBT

Answer 12

Market Value of Debt = D = PV (Future Interest Payments)

Question 13

WEIGHTED AVERAGE COST OF CAPITAL WITH TAXES

Answer 13

Another way to incorporate the benefit of the firm’s future interest tax shield.

rwacc = rE (E/(E+D)) + rD(1-Tc) (D/E+D)

The reduction in the WACC increases with the amount of debt financing.

The higher the firm’s leverage, the more the firm exploits the tax advantage of debt, and the lower its WACC.

Question 14

What is the risk of having more debt?

Answer 14

With more debt, there is a greater chance that the firms will default on its debt obligations.

A firm that has trouble meeting its debt obligations is in financial distress.

Question 15

BANKRUPTCY

Answer 15

A long and complicated process that imposes both direct and indirect costs on the firm and its investors that the assumption of perfect capital markets ignores.

Question 16

What are the direct costs of bankruptcy?

Answer 16

• Complex
• Time consuming
• Outside professionals usually hired
• The creditors may also incur costs during the process. They often wait several years to receive payment.
• Average direct costs are 3% to 4% of the pre-bankruptcy market value of total assets.

Question 17

What are the indirect costs of financial distress?

Answer 17

• Difficult to measure accurately, and often much larger than the direct costs of bankruptcy.
• Often occur because the firm may renege on both implicit and explicit commitments and contracts.
• Estimated potential loss of 10% to 20% of value.
• Many indirect costs may be incurred even if the firm is not yet in financial distress, but simply faces significant possibility that it may occur in the future.

e.g. loss of customers, suppliers, employees, etc.

Question 18

OPTIMAL CAPITAL STRUCTURE: The trade-off theory

Answer 18

Total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs:
VL = VU + PV(Interest Tax Shield)

Question 19

What key qualitative factors determine the present value of financial distress costs?

Answer 19

• The probability of financial distress

- The magnitude of the direct and indirect costs related to financial distress that the firm will incur.

Question 20

How does the probability of financial distress determine the present value of financial distress cost?

Answer 20

• The probability of financial distress increases with the amount of a firm’s liabilities (relative to its assets)
• The probability of financial distress increases with the volatility of a firm’s cash flows and asset values.

Question 21

How does the magnitude of financial distress costs vary?

Answer 21

Vary by industry.
e.g. technology firm will likely incur high financial distress costs due to the potential for loss of customers and key personnel, as well as a lack of tangible assets that can be easily liquidated.

Question 22

OPTIMAL LEVERAGE

Answer 22

• The trade off theory states that firms should increase their leverage until it reaches the level for which the firm value is maximised.
• At this point, the tax savings that result from increasing leverage are perfectly offset by the increase probability of incurring the costs of financial distress.

Question 23

What does the trade-off theory help to resolve about leverage?

Answer 23

• The presence of financial distress costs can explain why firms choose debt levels that are too low to fully exploit the interest tax shield.
• Differences in the magnitude of financial distress costs and the volatility of cash flows can explain the differences in the use of leverage across industries.

Question 24

AGENCY COSTS

Answer 24

Costs that arise when there are conflicts of interest between stakeholders.

Question 25

Why must there be a separation of ownership an control?

Answer 25

Managers may make decisions that:

• Benefit themselves at investors’ expense.
• Reduce their effort.
• Spend excessively on perks.
• Engage in “empire building”.

If these decisions have negative NPV for the firm, they are a form of agency cost.

Question 26

How does debt provide incentives for managers to run the firm efficiently?

Answer 26

• Ownership may remain more concentrated, improving monitoring of management.
• Since interest and principle payments are required, debt reduces the funds available at management’s discretion to use wastefully.

Question 27

What conflict is there between equity and debt holders? (agency costs)

Answer 27

-A conflict of interest exists if investment decisions have different consequences for the value of equity and the value of debt.
Most likely to occur when the risk of financial distress is high.
Managers may take actions that benefit shareholders but harm creditors and lower the total value of the firm.

-Excessive risk taking
A risky project could save the firm even if the expected outcome is so poor that it would normally be rejected.

-Under-investment problem
Shareholders could decline new projects.
Management could distribute as much as possible to the shareholders before bondholders take over.

Question 28

Consequences of too little leverage?

Answer 28

• Lost tax benefits
• Excessive perks
• Wasteful Investment
• Empire building

Question 29

Consequences of too much leverage

Answer 29

• Excessive interest
• Financial distress costs
• Excessive risk taking
• Under investment

Question 30

CONSEQUENCE OF LEVERAGE: Asymmetric Information

Answer 30

• Managers’ information about the firm and its future cash flows is likely to be superior to that of outside investors.
• This may motivate managers to alter a firm’s capital structure.

Question 31

CONSEQUENCES OF LEVERAGE: Leverage as a credible signal

Answer 31

• Managers use leverage to convince investors that the firm will grow, even if they cannot provide verifiable details.
• The use of leverage as a way to signal good information is known as the signalling theory of debt.

Question 32

CONSEQUENCES OF LEVERAGE: Adverse selection

Answer 32

• Suppose managers issue equity when it is overpriced.
• Knowing this, investors will discount the price they are willing to pay for the stock.
• Managers do not want to sell equity at a discount so they may seek other forms of financing.

Question 33

THE PECKING ORDER HYPOTHESIS

Answer 33

Managers have a preference to fund investment using retained earnings, followed by debt, and will only choose to issue equity as a last resort.

Question 34

MARKET TIMING

Answer 34

Managers sell new shares when they believe the stock is overvalued, and rely on debt and retained earnings if they believe the stock is undervalued.