Corporate Finance - R20 - Capital Structure

Question 1

a. explain the Modigliani–Miller propositions regarding capital structure, including the effects of leverage, taxes, financial distress, agency costs, and asymmetric information on a company’s cost of equity, cost of capital, and optimal capital structure;

Answer 1

Under the assumptions of no taxes, transaction costs, or bankruptcy costs, the value of the firm is unaffected by leverage changes. MM Proposition I (No Taxes) says capital structure is irrelevant.

MM Proposition II (No Taxes) concerning the cost of equity and leverage says that increasing the use of cheaper debt financing serves to increase the cost of equity, resulting in a zero net change in the company’s WACC. Again, the implication is that capital structure is irrelevant.

According to MM Proposition I (With Taxes), the tax deductibility of interest payments creates a tax shield that adds value to the firm, and the optimal capital structure is achieved with 100% debt. MM Proposition II (With Taxes) says that WACC is minimized at 100% debt.

Costs of financial distress are the increased costs companies face when earnings decline and the company has trouble paying its fixed costs. Higher amounts of leverage result in greater expected costs of financial distress.

The net agency costs of equity are the costs associated with the conflict of interest between a company’s managers and owners and consist of three components:

Monitoring costs.
Bonding costs.
Residual losses.
Costs of asymmetric information result from managers having more information about a firm than investors. The cost of asymmetric information increases as more equity is used in capital structure. Hence the pecking order theory. Pecking order theory states that managers prefer financing choices that send the least visible signal to investors, with internal capital being most preferred, debt being next, and raising equity externally the least preferred method of financing.

The static trade-off theory seeks to balance the costs of financial distress with the tax shield benefits from using debt and states that there is an optimal capital structure that has an optimal proportion of debt. Removing both MM’s assumptions of no taxes and no costs of financial distress, there comes a point where the incremental value added by the tax shield is exceeded by the additional expected costs of financial distress, and this point represents the optimal capital structure.

Question 2

b. describe target capital structure and explain why a company’s actual capital structure may fluctuate around its target;

Answer 2

The target capital structure is the structure that the firm uses over time when making capital structure decisions. In practice, the actual capital structure will fluctuate around the target due to management’s exploitation of market opportunities and market value fluctuations.

Question 3

c. describe the role of debt ratings in capital structure policy;

Answer 3

Mergers typically have goals to maintain a certain minimum credit rating when determining their capital structure policies because the cost of capital is tied to debt ratings; lower ratings translate into higher costs of capital.

Question 4

d. explain factors an analyst should consider in evaluating the effect of capital structure policy on valuation

Answer 4

Factors an analyst should consider when evaluating a firm’s capital structure include:

Changes in the firm’s capital structure over time.
Capital structure of competitors with similar business risk.
Factors affecting agency costs such as the quality of corporate governance.

Question 5

e. describe international differences in the use of financial leverage, factors that explain these differences, and implications of these differences for investment analysis.

Answer 5

Major factors that influence international differences in financial leverage include:

Institutional, legal, and taxation factors.
Financial market and banking system factors.
Macroeconomic factors