CHAPTER 6: CAPITAL STRUCTURE

Question 1

COST OF CAPITAL

Answer 1

Cost of capital is the return expected by investors for providing capital to a company.

It ensures that investors earn a return greater than what they could get elsewhere.

Question 2

Sources of Capital:

Answer 2

Companies can raise capital through equity, debt, or hybrid instruments.
Each source has a specific cost associated with it known as the component cost of capital.

Question 3

Risk and Return:

Answer 3

Higher-risk investments demand a higher rate of return.

Lower-risk investments require a lower rate of return to attract investors.

Question 4

Weighted Average Cost of Capital (WACC):

Answer 4

WACC is the weighted average of the costs of different sources of capital.

also called MARGINAL COST OF CAPITAL: because as the business grows, this cost changes: each additional unit of capital you raise, impacts the weights

WEIGHTS must represent the company’s TARGET CAPITAL STRUCTURE, not the current capital structure

It reflects the overall cost a company pays for financing its operations.

WACC is the appropriate discount rate to use for projects having similar risk profile as that of the firm

Question 5

Common Sources of Capital:

Answer 5

Common shares (equity)
Preferred shares
Debt

Question 6

WACC

Answer 6

required rate of return or discount rate

% of equity * Ke + % of debt * Kd * (1-T)

can break down ke into common & preferred equity=
% common * k of common
+
% preferred * k of preferred

Question 7

Weighting in WACC

Answer 7

Weights represent the company’s target capital structure, not necessarily the current one.

Adjustments are made to reflect changes in capital structure when raising new funds.

Examples:

Example calculations involve determining WACC using given weights and costs of debt, preferred stock, and equity.

WACC helps in evaluating projects and making capital budgeting decisions.

Question 8

CORPORATE LIFE CYCLE

Answer 8

Feature: Startup: Growth: Mature

Revenue Growth: Initial: Rising: Slowing
FCF: -ve: Rising: Stable
Business Risk: High: Medium: Low
Debt: None: Rising: High
Debt Type: Convertible: Secured: Unsecured

Question 9

Start-Ups:

Answer 9

Revenues close to zero; heavy investment needed.
Negative cash flow; high risk of business failure.
Capital raised mainly through equity, often from venture capital.
Debt financing is scarce and expensive; rarely a part of capital structure.

Question 10

Growth Businesses:

Answer 10

High revenue growth; ongoing investment required.
Cash flow may be negative but improving and predictable.
Risk of business failure decreases.
Equity remains the primary capital source; debt becomes available at reasonable terms as business attractiveness to lenders grows.
Debt used conservatively to maintain financial flexibility.

Question 11

Mature Businesses:

Answer 11

Revenue growth slows; investment spending decreases.
Positive and predictable cash flow.
Low risk of business failure.
Debt financing available at attractive terms, often unsecured.
Companies leverage debt significantly to capitalize on cheaper financing compared to equity.
Deleveraging may occur over time through share buybacks rather than dividends, enhancing shareholder value.

Exceptions:

1. Capital-Intensive Businesses:

Industries like real estate, utilities, and transportation.
High leverage throughout their lifecycle due to asset-backed collateral availability.

2. Capital-Light Businesses:

Software and technology sectors.
Minimal debt usage; rely more on equity due to low capital requirements and early positive cash flows.

Question 12

Determinants of the Costs of Debt and Equity

Answer 12

The costs of debt and equity are determined in the financial markets by top down factors that affect the overall market, as well as investor’s assessment of issuer specific factors.

1. Top-Down Factors

Costs determined by market-wide conditions and investor-specific assessments.

Cost of Debt: Risk-free rate + credit spread specific to the company.

Market Conditions: Impact benchmark rates and credit spreads; widen in recessions, tighten in expansions.

Debt Usage: Increases with lower benchmark rates or tighter credit spreads.

Companies may increase their use of debt when borrowing is less expensive due to
low benchmark interest rates and/or tight credit spreads, and vice versa.

Question 13

Issuer-Specific Factors:

1. Sales Risk
2. Profitability Risk
3. Financial Leverage
4. Collateral/Assets

Answer 13

Investor Assessment: Adjust rates of return based on:

1. Sales Risk: Stable (e.g., telecom subscriptions) vs. volatile (e.g., cyclical industries like autos).
2. Profitability Risk: Stable margins (fixed costs) vs. variable (operating leverage).
3. Financial Leverage: High leverage increases default risk; underleveraged firms can take on more debt.
4. Collateral/Assets: Strong assets (real estate, cash, receivables) support increased debt capacity.

Question 14

Issuer-Specific Factors:

1. SALES RISK
2. Profitability Risk
3. Financial Leverage
4. Collateral/Assets

Answer 14

Stability of revenue streams based on business model.

Example: Telecom companies like Vodafone with subscription-based revenues are stable.

Impact: Viewed positively for financial stability.

Contrast: Cyclical industries like automotive (e.g., Toyota) have volatile revenues tied to economic cycles, viewed negatively.

Question 15

Issuer-Specific Factors:

1. Sales Risk
2. PROFITABILITY RISK
3. Financial Leverage
4. Collateral/Assets

Answer 15

Stability of profit margins influenced by cost structure.

Key Factor: Proportion of fixed vs. variable costs determines profit margin stability.

Operating Leverage: Ratio of fixed costs to total costs.

Effect: Higher operating leverage amplifies changes in cash flow and profitability with revenue fluctuations.

Question 16

Issuer-Specific Factors:

1. Sales Risk
2. Profitability Risk
3. FINANCIAL LEVERAGE
4. Collateral/Assets

Answer 16

Influence of existing debt levels on capital structure decisions.

Risk: Highly leveraged firms face higher default risk and reduced capacity for additional debt servicing.

Benefit: Underleveraged firms can more easily support additional debt, enhancing financial flexibility.

Question 17

Issuer-Specific Factors:

1. Sales Risk
2. Profitability Risk
3. Financial Leverage
4. COLLATERAL/ASSETS

Answer 17

Assets that can secure debt or enhance borrowing capacity.

Examples: Real estate, automobiles, aircraft, and receivables from creditworthy customers.

Qualities: Strong collateral, cash-generating, fungible, or liquid assets.

Question 18

Modigliani-Miller Capital Structure Propositions (VERY IMP)

Theory 1. 1958: No Taxes
Theory 2. Then updated in 1963: With Taxes
Theory 3. Static-Tradeoff Theory: With Taxes & Cost of Financial Distress

XY Axis:
Y: Cost of debt & equity
X: D/E ratio

Theory 1.
Proposition 1: VL=VU
Proposition 2: As you increase DEBT in capital structure= Kd remains same; Ke keeps going up as RISK increases. WACC is SAME/UNCHANGED.

Theory 2.
Proposition 1: VL= VU + tD
(why? because of tax benefit)
Proposition 2: As you increase DEBT in capital structure= Kd doesn’t change; Ke goes up. Debt is a tax-deductible expense. So, WACC goes DOWN.

Theory 3.
Proposition 1: VL=VU + tD - PV (cost of fin-distress)
Proposition 2: As you increase DEBT in capital structure= WACC goes DOWN. But, in financial distress, there is a cost associated with bankruptcy i.e. the cost of financial distress.

The PV of financial distress at some point becomes more than the tax benefit at sometime. So, WACC starts going up.

U shaped curve. WACC first comes down & then increases.

MIGLIANI-MILLER HAVE 2 PROPOSITIONS FOR EACH OF THE 3 THEORIES

Answer 18

Overview: Capital structure (mix of debt and equity financing) does not affect a company’s overall value under certain ideal conditions.

Question 19

ASSUMPTIONS OF MODIGLIANI-MILLER CAPITAL STRUCTURE PROPOSITIONS

Answer 19

Assumptions:

1. Homogeneous Expectations: All investors hold the same expectations regarding bond and stock cash flows.
2. Perfect Capital Markets: No transaction costs, taxes, bankruptcy costs, and perfect information for all. No information asymmetry.
3. Risk-Free Rate: Investors can borrow and lend at a risk-free rate.
4. No Agency Costs: Managers always act in the best interest of shareholders.
5. Independent Decisions: Financing and investment decisions are independent; operating income is unaffected by capital structure changes.

Question 20

Capital Structure Irrelevance (MM Proposition I)

1958 THEORY

Answer 20

Statement: The market value of a company is independent of its capital structure.

Reasoning: Investors can replicate any desired capital structure through personal borrowing and lending, alongside holding company shares.

VL=VU

where,
VL= value of the levered firm
VU= value of the unlevered firm

why? because:
kE increases linearly (i.e. @45 degree angle); D/E on X axis.
kD remains same
WACC stays same

The size of the “pie” (total value of the company) remains constant regardless of how it’s divided between debt and equity.

These propositions form the basis for understanding how, under ideal conditions, a company’s value remains unchanged regardless of its debt-to-equity ratio.

In other words, the value of a company is determined solely by its cash flows, not
by the relative reliance on debt and equity capital.

Question 21

MM Proposition I (Capital Structure Irrelevance)

(MM Proposition I without Taxes)

1963 Theory:

Answer 21

The value of a company (V) is unaffected by its capital structure.

V= E + D

where,
E= value of equity
D= value of debt

Question 22

Weighted Average Cost of Capital (WACC):

Answer 22

The weighted average cost of capital (WACC) is unaffected by the capital structure.

% of equity * Ke + % of debt * Kd * (1-T)

The size of the “pie” (total value of the company) remains constant regardless of how it’s divided between debt and equity.

Figures show different capital structures (e.g., 70% equity, 30% debt vs. 70% debt, 30% equity) with the same total value of the company.

Question 23

MM Proposition II (Higher Financial Leverage Raises the Cost of Equity)

WACC REMAINS CONSTANT

Answer 23

The cost of equity

rE= r0 + (r0-rd) D/E
​
increases linearly with the company’s debt-to-equity ratio (D/E).

where,
r0: cost of capital for a company with zero debt (equity-only financed).
rd: cost of debt.
𝐷/𝐸: D/E is the debt-to-equity ratio.

Impact: Increasing D/E ratio raises the perceived risk to equity investors, leading to a higher required return (cost of equity).

Relation to MM Proposition I: Despite changes in D/E ratio and subsequent adjustments in WACC (weighted average cost of capital), the overall value of the company remains unaffected (MM Proposition I).

WACC Determination: WACC is primarily determined by the business risk of the company, not its capital structure.

These points summarize MM Proposition II, which explains how increasing financial leverage (higher debt-to-equity ratio) affects the cost of equity while keeping the WACC constant.

Illustration: As leverage increases, the cost of equity rises, while WACC and the cost of debt remain constant.

Question 24

MM Proposition I and II with Taxes

Answer 24

1. MM Propositions I and II traditionally ignore taxes.
2. With taxes considered, debt’s interest tax shield increases the company’s value if financial distress and bankruptcy costs are disregarded.

Question 25

WACC and Company Value: With taxes, WACC decreases as debt increases, thereby increasing overall company value.

Answer 25

With taxes, WACC decreases as debt increases, thereby increasing overall company value.

Optimal Debt Level: In theory, MM Propositions with taxes suggest that maximizing debt (100% debt) could be optimal in a tax-efficient environment, assuming no financial distress or bankruptcy costs.

Question 25

MM Proposition I with Taxes:

1963 Theory

Answer 25

VL= VU+tD

VL>VU (greater because of tax rate)

VL= value of levered firm
VU= value of unlevered firm
t= marginal tax rate
D= value of debt in capital structure
tD= debt tax shield

Question 26

MM Proposition II with Taxes:

1963 THEORY:

WACC GOES DOWN

Answer 26

r0 + (r0-rd)D/E

where,
r0: cost of capital for a company with zero debt (equity-only financed).
rd: cost of debt.
𝐷/𝐸: D/E is the debt-to-equity ratio.

Adjusted for the tax rate (t), the cost of equity increases less steeply with increasing debt compared to the scenario without taxes.

Impact: WACC DECREASES as debt increases, thereby increasing the overall company value.

These points summarize MM Propositions II and the introduction to MM Propositions I and II with Taxes, highlighting the effects of financial leverage and tax considerations on corporate valuation and cost of capital.

Question 27

Example

IFT has the following capital structure:
30 percent debt, 10 percent preferred stock, and 60 percent equity.

IFT wants to maintain these weights as it raises additional capital.

Interest expense is tax deductible.

The before tax cost of debt is 8 percent, cost of preferred stock is 10 percent, and cost of equity
is 15 percent.

If the marginal tax rate is 40 percent, what is the WACC?

Answer 27

ke= 15%
%e= 60%
kp= 10%
%p= 10%
kd= 8%
%d= 30%
t= 40%
(1-t)= 1-40%= 0.6

WACC = (0.3) (0.08) (0.6) + (0.1) (0.1) + (0.6) (0.15)
= 11.44 percent

WACC= ke%e + kp%p + kd%d (1-T)
= (0.15)(0.60) + (0.10)(0.10) + (0.08)(0.30)(0.6)
= 0.090.01* 0.0144
= 11.44%

Question 28

COST OF FINANCIAL DISTRESS:

STATIC-TRADEOFF THEORY

Answer 28

Impact of Leverage:

Operating and financial leverage magnify earnings downward during economic slowdowns, increasing financial stress on companies.

Question 28

2. The Cost of Capital

Machiavelli Co. has an after tax cost of debt capital of 4 percent, a cost of preferred stock of 8 percent, a cost of equity capital of 10 percent, and a weighted average cost of capital of 7 percent.

Machiavelli Co. intends to maintain its current capital structure as it raises additional capital.

In making its capital budgeting decisions for the average risk project, what is the relevant cost
of capital?

Answer 28

The relevant cost of capital is 7%. WACC remains same as given in question.

Since, they are maintaining the capital structure= weights are unchanged= thus WACC is the same

The WACC using weights derived from the current capital structure is the best estimate of the cost
of capital for the average risk project of a company.

Question 29

Types of Costs:

Answer 29

1. Direct Costs: Actual cash expenses incurred during the bankruptcy process, such as legal and administrative fees.
2. Indirect Costs: Include forgone investment opportunities, impaired business operations, and agency costs associated with managing debt during financial distress.

Question 30

Industry Variability:

Answer 30

Companies with assets having a ready secondary market (e.g., airlines, shipping companies) generally face lower costs of financial distress due to the ability to liquidate assets more easily.

Question 31

Factors Influencing Financial Distress:

Answer 31

1. Leverage: Higher leverage increases the probability of financial distress and bankruptcy.
2. Business Risk: Companies with higher inherent business risk are more susceptible to financial distress.
3. Corporate Governance and Management: Effective governance and management can mitigate the risks of financial distress by implementing sound financial practices and strategies.

Question 32

5. Optimal Capital Structure:

The optimal capital structure is the one that maximizes the value of the company.

Static Trade-off Theory:

Cost of Financial Distress comes in

U-Shaped CURVE

WACC comes down & then goes up

WACC is INVERSELY PROPORTIONAL TO VALUE OF THE FIRM

• WACC goes down so Value of Firm goes up
• Cost of Financial Distress starts catching up & Value goes down as WACC goes up

Answer 32

Static Trade-off Theory:

This theory balances the benefits of debt tax shields against the costs of financial distress (bankruptcy costs).

The value of a leveraged company VL is expressed as:

VL= VU + tD - PV (costs of financial distress)

where,
VU= value of unlevered firm
t= marginal tax rate
D= value of debt in capital structure
PV (costs of financial distress)= represents the present value of financial distress costs

Question 33

Optimal Debt/Equity Ratio:

Answer 33

Initially, adding debt increases firm value due to tax shields exceeding financial distress costs.

At the optimal point, the present value of financial distress costs equals the tax benefit of debt, maximizing firm value.

Beyond this optimal point, adding more debt increases financial distress costs more than the tax benefits, reducing firm value.

Question 34

WACC and Firm Value:

Answer 34

The optimal capital structure minimizes the Weighted Average Cost of Capital (WACC), aligning with the point of maximum firm value.

Question 35

Practical Considerations:

Answer 35

1. Target vs. Actual Structure: Companies aim to maintain a target capital structure but may deviate due to short-term financing opportunities or market fluctuations.
2. Uncertainty: It’s challenging to precisely determine the optimal structure due to uncertainties in estimating financial distress costs.
3. Optimal Range: Managers often define an optimal range of debt levels rather than a precise ratio (e.g., debt should be between 30% to 50%).
4. Flexibility and Adaptation: Companies adapt their capital structure based on market conditions and operational needs, aiming to balance risk and return effectively.

Question 36

A firm has the following capital structure: 20% debt, 10% preferred stock, and 70% equity. The before-tax cost of debt is 6%, cost of preferred stock is 8%, and the cost of equity is 12%. The firm’s marginal tax rate is 30 percent. The WACC is closest to:

A 10 percent.
B 9 percent.
C 12 percent.

Answer 36

%e= 70%= 0.7
ke= 12%= 0.12
%p= 10%= 0.1
kp= 8%= 0.08
%d= 20%= 0.2
kd= 6%= 0.06
t= 30%= 0.30
(1-t)= (1-0.3)= 0.7

WACC= (0.7)(0.12) + (0.1)(0.08) + (0.2)(0.06)(0.7)

A is correct.

Question 37

Which of the following costs is most likely tax deductible in some jurisdictions?

A Cost of Debt.
B Cost of Preferred Stock.
C Cost of Common Stock

Answer 37

A is correct. Interest costs are tax-deductible in some jurisdictions; they pass through the income statement and provide a tax shield.

After-tax cost of debt = Before-tax cost of debt x (1 – tax rate)

Question 38

Which of the following statement is least accurate about weighted average cost of capital (WACC)?

A It is also called the marginal cost of capital.
B The weights should represent the company’s the current capital structure.
C It is the appropriate discount rate to use for projects having a similar risk profile as that of the firm.

Answer 38

B is correct. The weights should represent the company’s target capital structure and not the current capital structure.

Question 39

Market Value vs. Book Value

When calculating D/E ratio= ALWAYS USE MARKET VALUES.

Answer 39

Optimal Capital Structure Calculation:

Should be based on the market value of equity and debt.

Question 40

Reasons for Using Book Values:

Answer 40

1. Market Fluctuations: Market values can be highly volatile and may not reflect the appropriate level of borrowing. A company with a rapidly increasing share price might opt to issue more equity rather than debt.
2. Management Perspective: Management focuses on the amount and types of capital invested by the company rather than in the company. This view is different from investors who buy securities at market prices.
3. Lenders and Rating Agencies: They typically rely on the book value of debt and equity for their calculations.
4. Opportunistic Financing Decisions: Managers consider share prices and market interest rates when deciding on the timing, amount, and type of capital to raise.

Question 41

Estimate the proportions of capital based on the following information:

Market value of debt: EUR50 million
Market value of equity: EUR60 million
Primary competitors and their capital structures (in millions):

Competitor: MV of Debt: MV of Equity
A: 25: 50
B: 101:190
C: 40:60

Calculate the proportions of debt and equity if the target capital structure is based on:

1. The current capital structure
2. Competitors’ capital structures
3. The company’s announcement that a debt-to-equity ratio of 0.7 reflects its target capital structure.

Answer 41

Wd= 50/50+60= 50/110= 0.4545
WE= 60/50+60= 60/110= 0.5454

Wd= (25/25+50) + (101/101+190) + (40/40+60)/3= 0.3601
We= (50/25+50) + (190/101+190) + (60/40+60)/3= 0.6399

3. DE= 0.7
   ASSUME: If E= 1; Debt= 0.7; D+E= 1.7

Wd= 0.7/1.7= 0.411
We= 1/1.7= 0.588

Question 42

5.2 Target Weights and WACC

Answer 42

Using Target Capital Structure:

If the target capital structure is known, it should be used in analysis.

Analysts often do not know the target capital structure and can estimate it by:

1. Current Capital Structure: Assuming the current capital structure, at market value weights, represents the target.
2. Trends and Statements: Examining trends in the company’s capital structure or management statements regarding capital structure policy.
3. Comparable Companies: Using the averages of comparable companies’ capital structures as the target.

Question 43

5.3 Pecking Order Theory and Agency Costs

Answer 43

1. Information Asymmetry:

Managers have more information about a company’s performance and prospects than outsiders (owners and investors).
Investors demand higher returns when information asymmetry is high, increasing the probability of agency costs.

2. Investor Observations:

Investors watch managers’ decisions for insights into the company’s future prospects.
Managers may signal confidence through their choice of financing methods, such as fixed payment commitments.

3. Pecking Order Theory:

Managers choose financing methods that send the least signal to outsiders.
Preferred hierarchy for financing:

1st Preference: Internal financing (retained earnings)
2nd Preference: Debt financing
3rd Preference: Equity financing

4. Agency Costs:

Incremental costs from conflicts of interest between managers, shareholders, and bondholders.
As debt use increases, agency costs to equity decrease.
High financial leverage limits managers’ freedom to incur additional debt or waste cash inefficiently.

5. Free Cash Flow Hypothesis:

High debt levels discipline managers to manage the company efficiently to meet interest and principal payments.
Reducing free cash flows limits managers’ opportunities to misuse cash.

Question 44

LO. Calculate and interpret the weighted
average cost of capital for a company

Answer 44

An issuer’s cost of capital is estimated using a weighted average of the costs of debt and equity, using either the current market value or management’s target weights of each type of financing as the weights.

WACC= ke%e + kp%p + kd*%d (1-T)

WACC represents the overall cost of capital for the firm and is the appropriate discount rate to use for projects having a similar risk profile as that of the firm.

Question 45

LO. Explain factors affecting capital structure and the weighted average cost of capital

Answer 45

Capital structure refers to the specific mix of debt and equity a company uses to finance its assets and operations. Issuers desire a capital structure that minimizes their weighted average cost of capital and generally matches the duration of their assets.

The total amount and type of financing needed usually depends on the issuer’s business model and its position in the corporate life cycle. As a company matures and progresses from start up to growth to maturity, its business risk typically decreases, and its operating cash flows turn positive and more predictable. This enables greater use of leverage at more favorable terms. Capital intensive businesses tend to use high levels of leverage irrespective of their maturity stage. Whereas, capital light businesses tend to use very little debt in their capital structure.

The component cost of debt and equity are impacted by top down factors such as financial market and industry conditions; and by issuer specific factors such as stability of revenues and profit margins, and operating and financial leverage.

Question 46

LO. Explain the Modigliani–Miller propositions regarding capital structure.

Answer 46

1). Without Taxes:

Proposition 1: VL=VU
Proposition 2: VL= VU+tD

2). With Taxes:

Proposition 1: rE= r0 + (r0-rd)D/E
Proposition 2: rE= r0 + (r0-rd)(1-t)D/E

Question 47

LO. Describe optimal and target capital structures

Answer 47

The optimal capital structure is the one at which the value of the company is maximized. The static
trade off theory is based on balancing the expected costs from financial distress against the tax benefits of debt service payments. Considering both the tax shield provided by debt and the costs of financial distress, the expression for the value of a leveraged company becomes:

VL= VU + tD - PV (costs of financial distress)

At the optimal debt/equity ratio point, the PV of financial distress is equal to the tax benefit of debt, and the firm value is maximum.

Question 48

In which stage of company’s life cycle, the cash flow may be negative but it is likely to be improving?

A Start-up
B Growth
C Maturity

Answer 48

B is correct.

In the growth stage, operating cash flow is still likely to be negative but may be improving and becoming more predictable. The company begins to establish a customer and supplier base.

Question 49

Which type of businesses tend to use high levels of leverage irrespective of their maturity stage?

A Capital intensive businesses
B Cyclical industries
C Capital-light businesses

Answer 49

A is correct.

Capital intensive businesses with marketable assets tend to use high levels of leverage irrespective of their maturity stage. Such businesses have underlying assets that can be bought and sold fairly easily and make for a good collateral.

Question 50

Which of the following statements is least accurate about the maturity stage in a company’s development?

A Revenue growth may slow or even begin to decline.
B Debt is used conservatively to retain operational and financial flexibility.
C Cash flow is usually positive and predictable.

Answer 50

B is correct. Mature companies typically use significant leverage because debt financing is easily available at this stage. A and C are correct statements about mature companies.

Typical changes in a company’s capital structure as it evolves are listed below:

Start-Ups:

1. In this stage a company’s revenues are negligible and a lot of investment is required to move from the prototype stage to commercial production.
2. Therefore, cash flow is usually negative.
3. The risk of business failure is high.
4. The company typically raises capital through equity rather than debt.
5. Equity is generally sourced through private markets (venture capital) rather than public markets.
6. Debt is generally not available or is very expensive. It is usually a negligible component of the capital structure.

Growth Businesses

1. In this stage a company typically experiences high revenue growth, but investment is needed to achieve this growth.
2. Cash flow may be negative, but it is likely to be improving and becoming more predictable.
3. The risk of business failure decreases.
4. Debt financing may be available at reasonable terms.
5. However, most companies use debt conservatively to retain their operational and financial flexibility.
6. Equity is generally the main source of capital.

Mature Businesses

1. In this stage a company typically experiences a slowdown in revenue growth and growth-related investment spending decreases.
2. Cash flow is usually positive and predictable.
3. The risk of business failure is low.
4. Debt financing is available at attractive terms often on an unsecured basis.
5. To take advantage of the cheaper debt (as compared to equity) companies typically use significant leverage.

Question 51

Modigliani-Miller Capital Structure Propositions (VERY IMP)

1. 1958: No Taxes
2. Then updated in 1963: With Taxes
3. Static-Tradeoff Theory: With Taxes & Cost of Financial Distress

XY Axis:
Y: Cost of debt & equity
X: D/E ratio

Theory 1.
Proposition 1: VL=VU
Proposition 2: As you increase DEBT in capital structure= Kd remains same; Ke keeps going up as RISK increases. WACC is SAME/UNCHANGED.

Theory 2.
Proposition 1: VL= VU + tD
(why? because of tax benefit)
Proposition 2: As you increase DEBT in capital structure= Kd doesn’t change; Ke goes up. Debt is a tax-deductible expense. So, WACC goes DOWN.

Theory 3.
Proposition 1: VL=VU + tD - PV (cost of fin-distress)
Proposition 2: As you increase DEBT in capital structure= WACC goes DOWN. But, in financial distress, there is a cost associated with bankruptcy i.e. the cost of financial distress.

The PV of financial distress at some point becomes more than the tax benefit at sometime. So, WACC starts going up.

U shaped curve. WACC first comes down & then increases.

MIGLIANI-MILLER HAVE 2 PROPOSITIONS FOR EACH OF THE 3 THEORIES

Answer 51

Modigliani-Miller Capital Structure Propositions (VERY IMP)

1. 1958: No Taxes
2. Then updated in 1963: With Taxes
3. Static-Tradeoff Theory: With Taxes & Cost of Financial Distress

XY Axis:
Y: Cost of debt & equity
X: D/E ratio

Theory 1.
Proposition 1: VL=VU
Proposition 2: As you increase DEBT in capital structure= Kd remains same; Ke keeps going up as RISK increases. WACC is SAME/UNCHANGED.

Theory 2.
Proposition 1: VL= VU + tD
(why? because of tax benefit)
Proposition 2: As you increase DEBT in capital structure= Kd doesn’t change; Ke goes up. Debt is a tax-deductible expense. So, WACC goes DOWN.

Theory 3.
Proposition 1: VL=VU + tD - PV (cost of fin-distress)
Proposition 2: As you increase DEBT in capital structure= WACC goes DOWN. But, in financial distress, there is a cost associated with bankruptcy i.e. the cost of financial distress.

The PV of financial distress at some point becomes more than the tax benefit at sometime. So, WACC starts going up.

U shaped curve. WACC first comes down & then increases.

MIGLIANI-MILLER HAVE 2 PROPOSITIONS FOR EACH OF THE 3 THEORIES

Question 52

MM Proposition II with corporate taxes (but no financial distress or bankruptcy costs) implies that:

A in the presence of taxes, the cost of equity falls as the company uses more debt
B as the company’s use of debt increases, its WACC increases and its value decreases.
C the use of debt is value enhancing in the presence of taxes.

Answer 52

As you increase DEBT in capital structure= Kd doesn’t change; Ke goes up. Debt is a tax-deductible expense. So, WACC goes DOWN.

As WACC goes down, value goes up

C is correct. MM Proposition II with taxes states that the cost of equity is a linear function of the company’s debt-to-equity ratio with an adjustment for the tax rate. It is represented as,

re=r0+(r0-rd )(1-t)D/E

This proposition implies that in the presence of taxes (but no financial distress or bankruptcy costs), the use of debt is value enhancing and, at the extreme, 100% debt is optimal.

A is not correct because the cost of equity increases as the company increases the amount of debt in its capital structure, but the cost of equity does not rise as fast as it does in the no tax case.

B is not correct because WACC for a leveraged company falls as debt increases, and therefore the overall company value increases.

Question 53

Which of the following companies is most likely to experience higher costs of financial distress?

A Airlines
B Shipping companies
C Information technology companies

Answer 53

Use CONTRAST (+-) GROUPING TRICK

A&B: Capital Intensive
But, C= has very few TANGIBLE assets that can be sold, thus risk of financial distress is more

C is correct. High-tech growth companies, pharmaceutical companies, information technology companies, and companies in the services industry typically have fewer tangible assets that can be sold. Therefore, these companies have higher costs associated with financial distress.

A and B are not correct because the costs of financial distress are lower for airlines and shipping companies since their assets have a ready secondary market.

Question 54

Which of the following is most accurate with respect to optimal capital structure?

A Debt can be a significant portion of the optimal capital structure.
B The optimal capital structure minimizes cost of debt.
C The actual capital structure is always the same as the optimal capital structure.

Answer 54

A is correct. Debt can be a significant portion of the optimal capital structure because of the tax-deductibility of interest.

The optimal capital structure minimizes WACC and maximises value of the company. A company’s optimal and actual capital structures may be different.

Question 56

Which of the following statements is least accurate about pecking order theory?

A Managers choose methods of financing with the greatest potential information content for outsiders.
B Managers prefer internal financing to debt.
C Equity is the least preferred method of financing.

Answer 56

A is correct. Pecking order theory suggests that managers choose methods of financing that send the least information signal to outsiders.

According to pecking order theory, the preferred hierarchy for financing is:

First preference: internal financing (retained earnings)
Second preference: debt financing
Third preference: equity financing

Question 57

Which of the following is least likely to be true with respect to agency costs in the context of a corporation?

A Agency costs arise from a conflict of interest between senior management and non management employees.
B High leverage reduces agency costs.
C The better a company is governed, the lower the agency costs.

Answer 57

A is correct. Agency costs are incremental costs that arise from conflicts of interest between managers, shareholders, and bondholders.

B and C are true statements about agency costs.

Agency costs arise due to conflicts of interest when an agent makes decisions for a principal.

All public companies and large private companies are usually managed by non-owners.

Therefore, agency costs are a consequence of a conflict of interest between managers and owners of a corporation. The better the corporate governance structure, the lower the agency costs.

Free Cash Flow Hypothesis: As per this hypothesis, high debt levels discipline managers by forcing them to make fixed debt service payments and by reducing the company’s free cash flow.

The more financially levered the company is, the less freedom managers have to misuse cash. Thus, high leverage will lower agency costs.