Corporate Finance: Capital Structure

Question 1

WACC

Answer 1

= D/v(rD)(1-Tr) + E/v(rE)

• • r = marginal cost of equity or debt
• Marginal = What it will cost to raise additional capital
• The weight is calculated from the “Value” of the firm. WACC goes down when debt is added even though debt increases the Re.*

Question 2

MM Proposition I without Taxes

Answer 2

1. There are no costs, lending is at Rfr and markets are efficient
2. Therefore there are no difference in value based on capital structure
3. Leveraged and unleveraged firms are equal and differences are irrelevant
4. Investors can create their own capital structures by leveraging their investment

Question 3

MM Proposition II (without taxes)
Include Regression Equation for Cost of Equity

Answer 3

1. The cost of equity is a positive linear function of the company’s debt-equity ratio: Re = Ro + D/E(Ro-Rd)
   * - Ro = cost of equity for unlevered firm*
2. Because debt has a priority over equity
3. WACC remains same regardless of adjustments in D/E

Question 4

Total Value of Company under Proposition II without Taxes

Answer 4

V = Int/Rd + EBT/Re

• • This assumes that debt and earnings are perpetuities so the perpetuity formula shoudl be used.*
• • Remember to net out interest payments from EBT*

Question 5

Cost of Equity MM II with Taxes

Answer 5

Re = Ro + [(Ro-Rd)(1-Tr)(D/E)]

Question 6

Value of Vl and Vu firms

Answer 6

1. Vl = Vu without taxes
2. Vl = Vu + (Tr)(D)
3. Ve + Vd = Vl
4. Ve + Vd = Vu + (Tr)(D)
5. Vu = Ve + Vd(1-Tr)

Question 7

Calculate Vu and Vl assuming taxes
EBIT = 10,000
TR = .4
Re = .1
Rd = .06
Vd = 25,000

Answer 7

Vu = EBIT(1-t) / RWacc
10,000(.06)/.1 = $60,000

Vl = Vu + (Tr X D)
$60,000 + 10,000 = $70,000

Question 8

The costs of financial distress and bankruptcy

Answer 8

1. Direct costs (legal, admin etc.)
2. Indirect costs (lost opportunity, impaired brand etc.)

Question 9

Agency Costs

Answer 9

1. Monitoring Costs (shareholders keeping an eye on management)
2. Bonding Costs (management’s costs to reassure shareholders - insurance etc)
3. Residual Loss (costs that can’t be eliminated through monitoring or bonding)

Question 10

Jensen’s Free Cash Flow Hypothesis

Answer 10

Higher levels of debt require managers to be more careful about cash flow and minimize potential to misuse funds.

Question 11

The Optimal Capital Structure: Static Trade-off Theory

Answer 11

Vl = Vu + Tr(D) - PV(Costs of Financial Distress)

- The value is maximized when the PV of financial distress is equal to the advantage of getting more debt. The WACC will start increasing at this point.