Class 13: Capital Structure with/without Taxes

Question 1

How do you calculate the leverage ratio of a firm?

Answer 1

Leverage Ratio = Debt/Assets ⇒ Debt/(Debt + Equity)

Question 2

How do you calculate the value of the entire firm (value of assets)?

Answer 2

Value of firm = Present Value of the FCFs discounted at the expected return of the assets.

Question 3

What are assets composed of (funded by)?

Answer 3

Assets are funded by both EQUITY and DEBT. So in reality we have 2 CAPMs, one for E and one for D.

Question 4

Why is the Beta of Debt lower than Beta of Equity?

Answer 4

Beta of D will be lower than beta of E, because in a recession debt holders get paid first (less risky = lower Beta)

Question 5

What’s the Discount Rate for the value of the firm (assets)?

Answer 5

The discount rate for he entire firm (the assets) is a weighted average of the debt cost of capital and the equity cost of capital. Weighted average of CAPM (D) and CAPM (E).

Question 6

What does the Beta of asset depend on? and what happens to it as we alter the amount of debt?

Answer 6

A firm’s asset beta (risk) depends mainly on the business/operations of the firm. It depends on the assets alone, it is the firm’s market risk. For example Boeing making planes, Louis Vuitton making fancy bags.

A firm’s asset beta does not change as we alter the amount of debt. Beta of assets is FIXED but unknown.

Question 7

What’s the beta of asset for an unlevered firm?

Answer 7

An unlevered firm means that the firm has no debt so D=0. In this case the Beta of Asset = Beta of equity.

Remember that you can get the beta of equity by running a regression

Question 8

How do you calculate the beta of asset of a private company?

Answer 8

Since B_A=B_E then you can obtain the equity beta from the stock returns of a comparable public firm. You calculate the beta using a regression, but you need public historical data.

Question 9

If the debt is risk free, then the beta of debt is equal to…?

Answer 9

zero

B_D=0 if debt is risk-free

Question 10

If the debt is risk free, then the return of debt is equal to…?

Answer 10

The risk free return

r_D=r_f

Because B_D=0 and cancels out the rest of the equation. The firm is as safe as the Treasury Department

Question 11

Is debt cheaper/better than equity?

Answer 11

NO! More debt makes equity riskier.

Increasing debt amount (even at low interest rates) increases the discount rate of the cashflows belonging to the shareholders.

Question 12

Why does Debt make the firm more valuable?

Answer 12

Because of the tax shield given that payments on interest are tax deductible. The benefits of a tax shield go to the shareholders, because as a debt holder all you get is coupon, coupon, coupon.