Corporate Finance #24 - Capital Structure

Question 1

Describe the Modigliani-Miller Propositions I and II under these assumptions:

1. no taxes
2. no transaction costs
3. no financial stress (i.e. bankruptcy) costs

Answer 1

LOS 24.a

MM Prop I - capital structure is irrelevant to a firm’s value because investor can create own leverage:

V_L = V_U

MM Prop II - cost of equity increases linearly as a company increases its proportion of debt financing:

r_e = r₀ + D/E(r₀ - r_d), where

r₀ = business risk
D/E(r₀ - r_d)

Question 2

List the initial simplifying assumptions for MM scenarios

Answer 2

LOS 24.a

1. Capital markets are perfectly competitive (i.e. no transaction costs, no taxes, no bankruptcy costs).
2. Investors have homogenous expectations (same ROA requirements).
3. Riskless borrowing and lending (i.e. at risk-free rate for owners and investors).
4. No agency costs (i.e. no conflict of interest between owners and shareholders).
5. Investment decisions unaffected by financing decisions (i.e. OpInc is independent of how assets are financed).

Question 3

Describe the Modigliani-Miller Propositions I and II under these assumptions:

1. WITH taxes.
2. no transaction costs
3. no financial stress (i.e. bankruptcy) costs

Answer 3

LOS 24.a

MM Prop I - optimal capital structure is 100% debt because the tax sheild adds value to the firm:

V_L = V_U + t*d, where

t = marginal tax rate
d = value of debt in capital structure
t\*d = tax sheild

MM Prop II - cost of equity increases linearly as a company increases its proportion of debt financing:

r_e = r₀ + D/E(r₀ - r_d)(1 - T_C), where

T_C = tax rate

Question 4

Costs of Financial Distress

Answer 4

LOS 24.a

Expected costs of financial distress has two components:

1. direct and indirect costs:
   - direct: cash expense of bankruptcy process
   - foregone investment opportunities; loss of trust
2. probability of of financial distress: higher leverage increases likelihood of finanical distress

Question 5

Net agency costs of equity

Answer 5

LOS 24.a

Net agency cost of equity - the costs associated with the conflicts of interest between managers (with no stake in company and its risks) and investors. Three componets:

1. monitoring costs - management is monitored through reporting to shareholders and paying board members
2. bonding costs - assumed by management to assure shareholders that they are working in their interests e.g. insurance premiums, non-compete agreements
3. residual losses - occur despite monitoring and bonding

​Agency theory: use of debt forces managers to be disciplined in how they spend cash because increased debt reduces free cash available for their own benefit.

Question 6

Costs of asymetric information

Answer 6

LOS 24.a

costs of asymetric information - costs resulting from managers’ greater knowledge of a firm’s prospects and future performance compared to shreholders and creditors. Firms having complex products or low transparency tend to have higher costs of asymetric information. Management’s choice between debt and equity can provide a signal to their opinion of the firm’s future prospects:

• issuing debt –> positive signal (management is confident)
• issuing equity –> negative signal (management believes firm’s stock is overvalued)

Question 7

Pecking oder theory

Answer 7

LOS 24.a

pecking order theory - management prefers to make financing decisions that are least likely to send signals to investors. Therefore, the pecking order is (most to least prefered):

• internally generated equity (retained earnings)
• debt
• external equity (issue new shares)

Question 8

Static trade-off theory and its effect on MM Props

Answer 8

LOS 24.a

static trade-off theory - managers will seek to balance costs of financial distress costs tax sheild benefits such that WACC is minimized (Prop II) and firm value is maximized (Prop I):

V_L = V_U + td - PV, where

PV = costs of financial distress

optimal proportion of debt is where marginal benefit of tax sheild is equal the marginal cost of financial distress

Question 9

Why does a firm’s actual capital structure fluxuate around the target (i.e. optimal) capital structure?

Answer 9

LOS 24.b

Two reasons:

1. management may choose to exploit temporary opportunities in a specific financing source (e.g. issue equity due to a temporary rise in stock’s value
2. market volatility causes changes in stock and bond prices

Question 10

Describe the role of debt ratings in captial structure policy

Answer 10

LOS 24.c

• reduces asymmetric information
• allows for better comparison of debt risk among firms
• managers prefer highest debt rating because it lowers their debt financing costs

Question 11

Yield spread between AAA and BBB bonds

Answer 11

LOS 24.c

• Typically, a difference of 100 basis points exists between the yields of Aaa and Baa bonds, though this spread widens in economic recessions.

Question 12

Considerations and methods in evaluating effects of a firm’s capital structure to firm’s valuation

Answer 12

LOS 24.d

Considerations include:

• change in capital structure over time
• compare capital structure of competitors with similar business risk
• company-specific e.g. quality of coporate governace

Methods:

• scenario analysis - assess how changes in firm’s debt ratio may reduce/increase firm’s WACC and valuation

Question 13

Describe international differences in the use of financial leverage

Answer 13

LOS 24.e

Total debt - Companies in Japan, Itlay and France tend to have higher D/E than USA and UK.

Debt maturity - N American companies tend to use longer maturity debt than companies in Japan.

Emerging vs. developed markets - companies in developed countries tend to use more debt (higher D/E) and use longer maturity debt than companies in emerging markets.

Question 14

Impact of country-specific factors on captial structure

Answer 14

LOS 24.e

Country-specific factor use of total debt debt maturity

Institutional & legal factors

strong legal system Lower Longer
less information asymmetry Lower Longer
more favorable tax rates on dividends Lower N/A
common law as opposed to civil law Lower Longer

Financial market factors

more liquid stock & bond markets N/A Longer
greater reliance on banking system Higher N/A
greater institutional ivestor presence Lower N/A
common law as opposed to civil law Lower Longer

Macroeconmic factors

higher inflation Lower Shorter
higher GDP growth Lower Longer