Capital Structure - Q1

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.

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, Industry capital structure, Taxes, Non-debt tax shields, Growth opportunities,

Question 6

MM’s (1963) ‘corrected’ Proposition III

Answer 6

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

VL = VU + Tc*D

Question 7

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 7

WACC
WACC
APV
APV

Question 8

arbitrage in MM model

Answer 8

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 9

implications of MM’s proposition 2

Answer 9

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 10

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

Answer 10

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 11

Summary of MM’s propositions

Answer 11

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 12

Direct costs of Bankruptcy

Answer 12

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, Warner (1977)
Costs are higher for firms with more complicated operations or large number of creditors.
Relatively higher for small firms

Question 13

examples of indirect costs of financial distress

Answer 13

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.
Overall costs for a distressed firm can be 10-23% of frim value (Andrade and Kaplan 1998) or 15-30% (Korteweg 2010)

Question 14

briefly describe the lemons problem

Answer 14

At a price based on average quality, high-quality sellers
have little or no incentive to sell their goods
George Akerlof in 1970

Question 15

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 15

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 16

consequences of adverse selection

Answer 16

• 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 17

Pecking order theory model setup

Answer 17

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 18

How does POT effect capital structure decisions

Answer 18

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 19

Pecking order of financing:

Answer 19

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

Question 20

Predictions of the POT

Answer 20

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’

Question 21

Intro to Pecking order theory essay

Answer 21

POT is a concept in corporate finances that suggests that managers should follow a hierachy when choosing their source of financing.
First proposed by Stewart myers and Nicholas Majluf in 1984, the theory states that firms should prioritise internal financing over debt and equity with equity financing a last resort.

Question 22

In POT why do we prefer internal financing

Answer 22

Minimising transaction costs such as underwriting spread or interest / repayment obligations
Avoiding debt covenants that may limit a companies financial flexibility ( strong survey evidence to support)
Lower risk exposure

Question 23

In POT why do we prefer Debt financing

Answer 23

Lower cost of capital as interest is tax deductible
Avoid dilution of ownership
Market signals
Debt can be structured flexibly to align with projected cash flows

Question 24

How does informational asymmetry effect POT, w.r.g equity financing

Answer 24

The lemons problem can be applied to equity financing. As a result of investors not having complete information about the companies true value or future prospects, they may fear that the company is overvalued or that managers are using equity issuance as a way to offload stock, this undervalues the stock

Question 25

Define informational asymmetry for the POT

Answer 25

In the context of Pecking Order Theory (POT), informational asymmetry plays a central role in shaping a firm’s financing decisions. Informational asymmetry refers to the situation where managers have more or better information about the company’s current value, future prospects, and risks than external investors, such as creditors or shareholders. This imbalance of information affects how external financing is viewed and priced, influencing the firm’s preference for internal versus external financing.
Ties back into signalling theory

Question 26

How does informational asymmetry effect POT, w.r.g debt financing

Answer 26

Due to asymmetry debt holders may charge a higher interest rate due to the higher perceived risk.
The reason debt is preferred over equity is that the confidence that the debt holders show in lending is a positive signal to the market of future cash flows

Question 27

How to structure the POT essay

Answer 27

Intro
informational asymmetry
why: internal financing, debt ,equity

Question 28

Overall predictions of the POT

Answer 28

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.
If firms have a financing deficit, they issue debt to offset it, unless debt capacity is reached
If firms have a surplus they retire debt before repurchasing equity

Question 29

what is the underinvestment problem

Answer 29

high-growth firms may reject positive NPV projects due to prohibitively high information costs of external equity

Question 30

What is the universal theory of TOT vs POT

Answer 30

No theory Myers 2001
The trade-off theory outperforms the pecking order
theory in nested models, Flannery and Rangan, 2006

Question 31

Opinions of Flannery and Rangan, 2006

Answer 31

The trade-off theory outperforms the pecking order
theory in nested models
UK and US firms adjust at rates of more than 50% and 30%,
respectively (showing firms adjust their leverage towards target rates)

Question 32

What did Fama and French find in 2005 that went against POT

Answer 32

67% of sample firms issue some equity each year between 1973-1982, and the proportion rises to 74% for 1983-1992 and 86% for 1993-2002
Firms are not reluctant to issue equity

Question 33

In POT what are the thoughts on issuing equity

Answer 33

Only as a last resort
Gives negative market signals as equity is only issued when stock is overvalued (backed up by survey evidence)

Question 34

Firms mainly use debt to offset their deficit, evidence?

Answer 34

Shyam-sunder and Myers 1999 Agree
mixed evidence from more recent data, Frank and Goyal 2003, who suggest small, high growth firms like to issue equity, this inconsistent with POT but could be because small companies don’t have access to debt capital (Lemmon and Zender, 2010)

Question 35

POT vs TOT
Profitability

Answer 35

Consistent with POT, negative sign
The higher the profitability, the lower the level of leverage
If a firm is profitable, it doesn’t need to issue debt capital

Question 36

POT vs TOT
Asset tangibility

Answer 36

Consistent with TOT, positive sign
If you have a company with tangible assets, it is very easy to issue debt as tangible assets can be collateralised.
Bankruptcy and financial distress costs are low as tangible assets have a high value

Question 37

POT vs TOT
Firm Size

Answer 37

Consistent with TOT, positive sign
A large company usually has a lower cost of debt capital, company also is more diversified meaning the cost of financial distress is lower.
We know this because proportionally, cost of financial distress are larger for smaller companies

Question 38

POT vs TOT
Industry differences

Answer 38

Consistent with TOT, positive sign
shows that firms within the same industry follow the capital structure of their peers, meaning they have a target leverage

Question 39

POT vs TOT
Market to book (MTB)

Answer 39

Higher the MTB the higher the level of growth opportunities
Because when the market value is high compared to the book value it means that the market value is mainly to do with intangible assets or growth opportunities that you cannot find in the book.
high growth company should not borrow a lot, based on TOT, as they are likely to suffer a lot with financial distress
However not entirely consistent with POT becuase companies with high MTB / growth opportunities will not be able to rely on internal funds

Question 40

Intro for trade of theory

Answer 40

The trade-off theory of capital structure suggests that firms aim for a target leverage ratio that achieves the optimal balance between the benefits of the debt interest tax shield and the costs associated with financial distress and bankruptcy, due to the level of leverage.
the theory was first suggested by Kraus and Litzenberger in 1973, building upon the foundation built by economists, Modigliani and Miller.

Question 41

Survey evidence for Trade of theory

Answer 41

Graham (2022): 980 North American firms (CFOs)