Debt Policy

Question 1

What does Capital structure mean?

Answer 1

It is how the firm is financed. The mix of different securities issued by the firm to finance its operations.
Debt: Corporate bonds, bank loans
Equity: Common stock, private equity
Preference shares
Warrants
Convertible bonds
Other hybrid securities

Question 2

What are the choices on Capital structure?

Answer 2

Debt/equity mix
Maturity structure of the debt
Seniority of claims
Options and conversion features
Currency-mix

Question 3

What is financial leverage?

Answer 3

It is the ammount of borrowings (debt) versus the ammount of capital

Question 4

What are the 2 definitions of leverage?

Answer 4

Leverage(1)=Debt/Equity
Leverage(2)=Debt/Assets=Leverage(1)/(1+Leverage(1))
Assets=debt+equity

Question 5

Why does leverage matter for the firm?

Answer 5

Leverage increases the financial risk. This may increase the cost of funding for some sources of funding (debt and equity)

Question 6

Why does leverage matter for the investor?

Answer 6

Firms may not always issue the securities the investor wants (e.g. levered equity)
Investors may be willing to pay a premium for the securities (risk profiles) they want.

Question 7

What are the assumptions in M.M. proposition 1?

Answer 7

We assume perfect, frictionless markets (there are no discriminating taxes, no cost of financial distress and investors and firms can trade in the financial markets at the same terms)
We assume that cash flows are given (The investment and operating policies of the firm are given and there is no impact of leverage on managers incentives)

Question 8

Given M.M. proposition 1, does capital structure matter?

Answer 8

No, the value is independent of the firms capital structure

Question 9

What if a firm is levered and the investor wants an unlevered firm?

Answer 9

The investor can buy both equity and debt.
The other way around the investor can lend money to create his own leverage (home made leverage)

Question 10

Can you earn money with a new capital structure?

Answer 10

Probably not, but could be possible if either:
The new capital structure does change cash flows, e.g. save taxes or other transaction costs
or:
Investors demand the new securities you want to issue and there is no competition from other issuers for this security and investors can not replicate (homemake) this security (nor can investment banks do it for them).

Question 11

What does M.M. proposition 2 say?

Answer 11

In frictionless financial markets where the firm’s cash flows are given, its cost of capital does not depend on its capital structure.

Question 12

What is WACC?

Answer 12

Weighted average cost of capital. We can calculate the cost of capital as a weighted average of the cost of debt and the cost of equity

Question 13

What is the WACC formula?

Answer 13

rA=WACC=rE(E/V)+rD(D/V)

Question 14

How do you calculate the cost of capital?

Answer 14

Determine rE and rD from an asset pricing model (CAPM)
E and D are given as market values

Question 15

What can you use WACC for?

Answer 15

Use WACC for capital budgeting and company valuation

Question 16

What two risks does return on equity reflect compensation for?

Answer 16

The business risk, as reflected in rA
The financial risk, as reflected in the spread rE-rA

Question 17

What is tax-adjusted cost of capital?

Answer 17

Assume that the tax system discriminates:
Interest paid from pre-tax profits
Dividends and capital gains from after-tax profits

Question 18

What is the subsidy interest payments recieve?

Answer 18

(rdD)T
Interest payments times the tax advantage of interest payments over dividends and retained earnings

Question 19

What is the after-tax WACC formula?

Answer 19

rWACC=rE(E/V)+rD(1-T)(D/V)

Question 20

How can the firm’s treasurer package the cash flow?

Answer 20

As interest payments to debtholders and as dividends and retained earnings to equityholders