Debt Policy and Capital Structure (L8)

Question 1

capital structure

Answer 1

mix of debt and equity

Question 2

leverage

Answer 2

existence of debt

Question 3

unlevered

Answer 3

no debt, all equity finance

Question 4

modigliani & miller proposition 1 (without tax or bankruptcy cost)

Answer 4

market value isn’t affected by capital structure (equity/debt) so any mix of them is fine as long the projects they undertake have a positive NPV
Vl=Vu=EBIT/WACC
earning before interest/tax (cash flows) / weighted average cost of capital = value levered or not (firm value always stays the same)

Question 5

modigliani & miller proposition 2 (without tax or bankruptcy)

Answer 5

the cost of equity (r) increases in proportion to the equity ratio (D/E)
rL=rU+(rU-rd) x D/E

Question 6

modigliani & miller theorem (tax, no bankruptcy)

Answer 6

interest expense is tax deductible, with debt tax liability is reduced so cash flow is increased for investors (debt holders get whatever interest, after tax income goes to shareholders)
Vl=Vu+ PV(interest tax shields)
r=rU+(rU-rd)xD/Ex(1-Tc)

Question 7

annual interest tax shield

Answer 7

tax saving because of interest expenses (from borrowing money)
Tcx(rdxD)

Question 8

PV of interest tax shields

Answer 8

Tcx(rdxD)/rd=Tc x D

Question 9

WACC after tax

Answer 9

E/V x r + D/V x rd (1-Tc)

Question 10

value of the firm after tax etc

Answer 10

Vl=Vu+ PV(interest tax shields)

Question 11

considering tax & bankruptcy cost

Answer 11

bankruptcy cost is an expected cashflow that changes the value of the firm

Question 12

what are bankruptcy costs

Answer 12

direct: lawyer fees,court fees,other admin fees
indirect:loss of customers, goodwill of company

Question 13

value of firm considering tax and bankruptcy

Answer 13

Vl=Vu+PV(interest tax shields) -PV(bankruptcy costs)
value goes up at a lower right