Finance Topic 4

Question 1

Capital structure

Answer 1

-blend debt & equity impacts firms and SH wealth and value

-financing decision - mix of equity vs debt = influence value & wealth
—discount rate in valuation
—level of gearing/leverage and if so in what way and what extent

Question 2

Gearing/leverage various metrics

Answer 2

Question 3

Establishment and operation of the firm

Answer 3

Question 4

3 Approaches/ideas to capital structure

Answer 4

1. Traditional (discursive)
2. Pecking order (discursive)
3. Modigliani & Miller (theoretical, algebraic)

Each = studied empirically

Question 5

Traditional view on capital structure

Answer 5

Finance provider, risk of debt < risk of equity therefore costs are the same

-traditional view = some optimal capital structure min WACC, at finite leverage
- debt increase from 0, equity holders benefit from effect of relatively low cost of debt = perceive little additional risk = WACC falls
-debt increase further, still benefit from low cost of debt but extra risk to equity holders outweighs benefit WACC levels out/starts to rise
-debt rise even further, extra risk = dominates, debt providers demand higher returns cost of debt rises and WACC rises further

-corp tax = no real affect, corp tax means cost of debt is even lower

Question 6

Graphs for traditional view

Answer 6

Optimal point of leverage/gearing = WACC minimised, value maximised
Gearing too low = increase value & SH wealth via taking on more debt
Debt too high = drop leaverage, issue equity/pay back debt

Question 7

Pecking Order theory

Answer 7

Issues of ease and costs of raising finance are paramount (Speed and ease and cost of acquisition)
-only talking upfront about acquisition not ongoing

Question 8

Order of preference for pecking order theory
5 things

Answer 8

1. Retained earnings
2. WCM (stock/cash mngment)
3. Private debt (bank loan) - more effort and costly with acquisition
4. Debt issue
5. Equity issue

1,2 = internal sources of funding
1 = at top in terms of ease and cost of acquisition,
Cost of equity increase going down
4, 5 = expensive to make and consume as services are used

Question 9

Modigliani and miller
9 Explicit and implicit assumptions

Answer 9

NONE ARE TRUE
1. Capital markets are frictionless
2. Individuals can lend/borrow at risk free rate
3. no cost to bankruptcy
4. Firms issue only 2 types of claims - risk free debt and (risky) equity
5. All firms are assumed to be in same risk class
6. Corporate taxes are only form of government levy
7. All cash flow streams are perpetuities - no growth
8. Corporate insiders/outsiders have same info (no signalling opportunities)
9. Managers always maximise sH wealth (no agency costs)

Question 10

Signaling

Answer 10

the act of using insider information to initiate a trading position

Question 11

M & M1 formulae

Answer 11

Question 12

Rho

Answer 12

Cost of equity of firm if the firm was all equity financed (no debt)
Particular Ke number

Question 13

Levered vs unlevered firm

Answer 13

no debt = unlevered firm
has debt in its capital structure = levered firm.

Absence of tax, mkt value fo firm = independent of capital structure and given by present value of its expected NOI discounted at rate ρ appropriate to its risk class

Present of corp tax = mkt value of levered firm exceeds value of equivalent unlevered firm by amount equal to market value of its debt multiplied by corp tax rate it faces

Question 14

Substitution for B market value of debt in M&M1

Answer 14

Question 15

Formulae for market value of debt B

Answer 15

Amount debt providers are demanding = what company contractually required to give them

Question 16

M&M2 formulae

Answer 16

-absence of tax, firm cost of equity increases linearly with increasing leverage (as measured by ratio of market value of its debt to the market value of its equity) slope of increase being excess of the all equity financed rate ρ appropriate to its risk class above the cost of debt

-presence of corp tax, slope of increase of the firms costs equity being reduced by factor (1-tc) as compared to the ‘no tax’ case

Question 17

M & M3 formulae

Answer 17

-absence of tax, firms WACC = all equity financed rate ρ appropriate to risk class

-presence of corp tax, firms WACC decreases with increasing leverage as measured by ratio of market value of its debt to total market value of firm) asymptotically towards a limit being the all equity financed rate ρ appropriate to its risk x (1-tc)

Question 18

WACC: traditional vs M&M formulae

Answer 18

Substitute M&M2 expression for ke into traditional WACC formulae and rearrange

Question 19

M&M view - no tax

Answer 19

-no tax economy = gearing has no effect on firm value
-level of gearing is irrelevant

Question 20

M&M view with corporate tax

Answer 20

If in with corp tax economy facing corp tax, debt is good for firm value

Question 21

M&M results validity

Answer 21

-holds for firms of differing risk, different values of ρ (associated with business risk)
-hold when both equity and debt are risky
-each case, provided no costs to bankruptcy (insolvency for companies)

Question 22

Costs of bankruptcy

Answer 22

Stop trading, liabilities roughly the same
Asset value dives

Question 23

4 Reasons the asset value dives is:

Answer 23

1. Reduced strategic options
2. Mngment tend to adopt inappropriate panic tactics
3. Forced sales (sell assets)
4. Cost of insolvency process