Capital Structure

Question 1

MM proposition I (no taxes)

Answer 1

Under the assumptions of no taxes, transaction costs, or bankruptcy costs, the value of the firm is unaffected by leverage changes; capital structure is irrelevant

Question 2

MM proposition II (no taxes)

Answer 2

Concerning the cost of equity and leverage: increasing the use of cheaper debt financing serves to increase the cost of equity, resulting in 0 net change in company’s WACC. Implies that capital structure is irrelevant.

Question 3

MM proposition I (with taxes)

Answer 3

The tax deductibility of interest payments creates a tax shield that adds value to the firm, and the optimal capital structure is achieved and WACC is minimized at 100% debt

Question 4

Net agency costs of equity

Answer 4

Costs associated with the conflict of interest between a company’s managers and owners and consist of 3 components: monitoring costs, bonding costs, residual losses.

Question 5

Static trade-off theory

Answer 5

Seeks to balance the costs of financial distress with the tax shield benefits from using debt and states that there is an optimal capital structure that has an optimal proportion of debt where the incremental value added by the tax shield is exceeded by the additional expected costs of financial distress (removing assumptions of no taxes and no costs of financial distress)

Question 6

Cost of equity

Answer 6

Re = Ro + (Ro - Rd)(1-t)(D/E)