capital structure in a world of perfect markets

Question 1

what is capital structure

Answer 1

the mix of financing instruments (shares, preferred stock, bonds) a firm uses to fund its investments
- a firms capital structure is broadly composed of debt and equity

Question 2

what ratios are used to measure the degree of leverage in a company’s financing

Answer 2

1. debt-equity ratio = debt/ equity
2. debt ratio = debt / (debt + equity)
   - shows proportion of total long term financing formed by debt

Question 3

what are the features of a perfect capital market

Answer 3

1. no taxes
2. no transaction costs
3. no asymmetric information or differences of opinion
4. bankruptcy is possible but theres no costs of financial distress
5. individuals and firms can borrow and lend at the same interest rate
6. investment cash flows are independent of financing choices

these assumptions provide a benchmark world to compare against and so offer insight into the determinants of capital structure

Question 4

what did Modigliani and Miller show

Answer 4

in a world of perfect capital markets, the choice of capital structure is irrelevant for the valuation of a firm = MM proposition 1

• cash flows generated by the firm’s investments are unchanged when the firm has a different capital structure
• since value of the company is calculated as the present value of future cash flows = the capital structure cannot affect it
• the cash flows are now just allocated differently between equity and debt holders

Question 5

what does MM show

Answer 5

under MM proposition 1
- value of leveraged firm = value of unleveraged firm
( leveraged = financed by both equity and debt)
(unleveraged = equity financed firm)

shows that it doesn’t matter if an equity investor preferred a different capital structure to the one the firm has chosen
- investors can create their own degree of leverage (homemade leverage)
- if they prefer an alternative capital structure, investors can lend or borrow on their own and achieve the same result
- homemade leverage = perfect substitute for firm leverage in perfect capital markets

Question 6

what is the cost of capital fallacy

Answer 6

e.g.
XYZ company
- has unleveraged cost of equity of 12%
- cost of debt of 6%
- debt is ‘cheaper’ source of financing
- some would thing XYZ should finance itself with only debt
- could imply that the company would be valued more if 100% debt financed

Question 7

what is wrong with he argument of cost of capital fallacy

Answer 7

• debt is riskier than equity for the company
• debt involves a contractual obligation to pay interest and repay principal
• equity doesn’t have this legal obligation
• if company cannot meet its obligations = declared bankrupt
• the greater risk of bankruptcy will affect equity investors
• equity investors rank below debt holders in the event of bankruptcy when it comes to repayment of their claim
• increase in debt by company = equity investors increase the required return to compensate for the greater risk
• levered cost of equity (cost of equity when firm also has debt in the capital structure) will rise

Question 8

what is the cost of capital in a frictionless world

Answer 8

the company cost of capital is independent of leverage and always equal to the unleveraged cost of capital

Question 9

what is MM proposition 2

Answer 9

cost of equity of a levered firm increases in proportion to the debt-equity ratio

or

cost of capital of levered equity = the cost of capital of unlevered equity plus a premium that is proportional to the ratio of debt to equity

Question 10

what is earnings per share

Answer 10

EOS = net income/ shares outstanding
- widely used financial performance ratio
- can be a useful metric for evaluating a company’s profitability on a per-share basis