Capital Structure (Week 7)

Question 1

What is the cost of equity?

Answer 1

The minimum rate of return that shareholders expect to get in order to buy XYZ shares.

Question 2

What does it mean when debt is issued ‘at par’?

Answer 2

The market value of the debt is equal to its face value

Question 3

How do you calculate the cost of debt when the debt is risky?

Answer 3

Compute the IRR of expected cash flows to debt holders, taking the probability of default into account.

Question 4

What is Capital Structure?

Answer 4

The mix of financial claims to a stream of cash flows.

There are two generic claims: Debt and Equity

Question 5

What is the proportion of debt in the capital structure called?

Answer 5

Leverage

Question 6

What is the company’s overall cost of capital?

Answer 6

The weighted-average cost of all sources of funding. It reflects the risk of the overall business which is the combined risk of the firm’s equity and debt.

Question 7

Company Cost of Capital equation

Answer 7

r_e is the equity cost of capital

• the rate of return that the equity-holders expect to receive
• The Capital Asset Pricing Model (CAPM) is a practical way to estimate it

r_D is the debt cost of capital

• The rate of return that the debt-holders expect to receive.
• If there is little risk the firm will default, the YTM is a reasonable estimate of investors’ expected rate of return.
• If there is significant risk of default, YTM will overstate investors’ expected return.

Question 8

A firm is considering the following project:

The project cash flows depend on the overall economy and thus contain market risk. As a result, investors demand a 10% risk premium over the current risk-free interest rate of 5% to invest in this project. What is the NPV of this project?

Answer 8

The cost of capital for this project is

r_f + Risk Premium = 5% + 10% = 15%

The expected cash flow in one year is:

1/2(1400) + 1/2(900) = $1150

The NPV of the project is:

NPV = -800 + 1150/1.15 = -800 + 1000 = $200

Question 9

Suppose the firm finances this project only by issuing equity (no debt). How much would investors be willing to pay for all of the firm’s shares?

• Expected cash flow in Y1 is $1150
• Cost of capital = 15%

Answer 9

• The equity in a firm with no debt is called unlevered equity.
• The cash flows of the unlevered equity are equal to those of the project. The value of the unlevered equity is therefore:

PV(Equity Cash Flows) = 1150/1.15 = $1000

• So the firm can raise $1000 by selling equity, pay the investment cost of $800, and keep the remaining $200, the NPV of the project, as profit.

Question 10

What is the equity in a firm with no debt called?

Answer 10

Unlevered equity

Question 11

What is the expected return on the unlevered equity? What is the volatility of the return?

Answer 11

Question 12

What is the equity in a firm called that has debt outstanding?

Answer 12

Levered equity

Question 13

What impact does adding leverage have to risk and required return of equity?

Answer 13

Adding leverage increases the risk and required return of equity, even when there is no risk that the firm will default.

Debt is paid first, and thus has no (or little) risk.

Equity has “more concentrated” risk.

Question 14

What impact does adding leverage have on cost of capital?

Answer 14

Adding leverage does not change the firm’s cost of capital.

Even though debt is “cheaper”, the cost of equity goes up by enough to elimiate any benefit

Question 15

Does adding leverage change the total valye of the firm?

Answer 15

No

Question 16

What is the Modigliani-Miller Proposition I (1958)?

Answer 16

Under a set of conditions referred to as perfect capital markets, the total value of a firm is equal to the market value of the total cash flows generate by its assets and is not affected by its choice of capital structure.

Question 17

What are the 5 assumptions in a perfect capital market?

Answer 17

1. No taxes
2. No asymmetric information or differences of opinion
3. No transaction costs
4. No costs of financial distress
5. Individuals and firms can borrow and lend at the same interest rate

Question 18

What is the expected return on the company’s assets (asset cost of capital or unlevered cost of capital? [based on Modigliani Miller proposition)?

Answer 18

Equal to the company’s cost of capital (pre-tax WACC)

Question 19

Argument:

• Cost of equity = 15%
• Return on riskless debt = 5%
• As debt is “cheaper” than equity, I should lever up my firm to reduce its cost of capital.

What do you answer?

Answer 19

Wrong.

There is a hidden cost of debt:

Raising more debt makes existing equity and debt more risky.

People often confuse the two meanings of “cheap”

Good deal and low cost are not the same thing.

Question 20

What is the Earnings Per Share Fallacy?

Answer 20

“Debt is desirable when it increases earnings per share”

EPS can go up (or down) when a company increases its leverage (True).

Companies should therefore not choose their financial policy to maximize their EPS.

It’s true that leverage may increase EPS. but higher EPS doesn’t imply higher prices.

Question 21

Equation for firm value

Answer 21

Firm value = Expected CF / cost of capital [k_a]

Question 22

Equation for share price

Answer 22

Share price = market value of equity / number of shares

Question 23

What is the market value of debt when debt is fairly priced?

Answer 23

If it is fairly priced (the firm is not being ripped off), the market value of debt is equal to the amount borrowed (£100m).

Question 24

What is the reason behind the EPS fallacy?

Answer 24

• EBIT is unaffected by a change in capital structure
• Creditors receive the safe (or the safest) part of EBIT
• Expected EPS might increase, but EPS has become riskier!
• The cost of equity (k_e) increases with leverage, and perfectly offsets the increase in expected EPS.