Corp Fin Lvl 2: Reading #24 Capital Structure

Question 1

Explain MM Proposition I (no taxes)

Answer 1

(no taxes) “the value of a firm is unaffected by its capital structure.” Says that it doesn’t matter how the firm finances its operations. What matters is the size of the firm, not how it is structured. It says the Value of the company with leverage = value of comp without leverage

Question 2

Explain MM Proposition II (no taxes)

Answer 2

“the cost of equity increases linearly as a company increases its proportion of debt financing” (“debtholders ahv priority claim –> value down, but risk to equity holders –> value up, therefore using debt is offset by increase equity resulting in no change to WACC”

Question 3

Explain MM Proposition I (taxes)

Answer 3

Value is maximized @100% debt. “Tax shield provided by debt” this is because “interest pymts are pretax expense and tax deductible but dividends are taxed. Use of debt for financing encouraged due to tax shield.

Question 4

Explain MM Proposition II (taxes)

Answer 4

WACC is minimized @100% debt

Question 5

Formula: Value of levered firm with tax shield

Answer 5

V levered = V unlevered x (t x d), where t = marg. tax

Question 6

DEFINE: agency costs of equity

Answer 6

“refer to costs associated with the conflicts of interest btwn management and owners”

Question 7

DEFINE: net agency cost of equity

Answer 7

shareholders aware of conflicts btwn their interest and mgmt’s, mgmt takes steps to minimize these costs and this is the net affect

Question 8

DEFINE: monitoring costs

Answer 8

part of agency costs of equity: costs associated with supervising mgmt (including paying board). Strong corp governance will reduce monitoring costs

Question 9

DEFINE: Bonding costs

Answer 9

part of agency costs of equity: “things to assure shareholders that managers are working in shareholders’ best interests.” includes premiums for insurance

Question 10

DEFINE: Residual losses as an agency costs

Answer 10

“may occur even with adequate monitoring and bonding provisions because such provisions do not provide a perfect guarantee”

Question 11

DEFINE: costs of asymmetric information

Answer 11

“costs resulting from fact that managers typically have more info about comp’s prospects and future performance than owners”

Question 12

Neg signal for asymmetric info:

Answer 12

issuing equity because shows managers may believe firm is overvalued

Question 13

Pos signal for asymmetric info:

Answer 13

“taking commitment to make fixed interest payments through debt financing because it signals they can make the payments”

Question 14

DEFINE: pecking order theory

Answer 14

“based on asymmetric info, related to the signals mgmt sends.” Means “managers prefer to make financing choices that are least likely to send signals to investors.”

Question 15

What is pecking order from most favored to least?

Answer 15

1. internally generated equity (i.e. retained earnings) 2. Debt 3. External equity (i.e. new shares).