Financial Leverage and Capital Structure Policy

Question 1

How should a firm go about choosing its debt– equity ratio?

Answer 1

as always, we assume that the guiding principle is to choose the course of action that maximises the value of a stock

Question 2

the change in the value of the firm is the same as

Answer 2

the net effect on the stockholders

Question 3

Why should financial managers choose the capital structure that maximizes the value of the firm?

Answer 3

Because it will maximise the value of the shareholder

Question 4

What is the relationship between the WACC and the value of the firm?

Answer 4

the value of the firm is maximized when the WACC is minimized.

Question 5

What is an optimal capital structure?

Answer 5

if it results in the lowest possible WACC. This optimal capital structure is sometimes called the firm’s target capital structure as well.

Question 6

financial leverage refers to ?

Answer 6

the extent to which a firm relies on debt. The more debt financing a firm uses in its capital structure, the more financial leverage it employs.

Question 7

What is the formula for ROE?

Answer 7

Return on Equity = Earnings or Net Income / Total Equity Return on Equity = EPS / Share Price

Question 8

What is the formula for EPS?

Answer 8

Earnings Per Share = Earnings or Net Income / Shares

Question 9

What happens to (Recission/Expected/ Expansion) EPS and ROE when an all-equity firm introduces Debt?

Answer 9

Recession: ROE and EPS will be lower compared to without debt. Expansion: ROE and EPS will be higher compared to without debt. “illustrates how financial leverage acts to magnify gains and losses to shareholders.”

Question 10

What is homemade leverage?

Answer 10

use of personal borrowing to alter the degree of financial leverage is called (shareholders can borrow and lend on their own)

Question 11

What is the effect of financial leverage on shareholders?

Answer 11

It depends on the company’s Earnings Before Interest and Tax. If the EBIT is high, leverage is good as it increases returns ROE & EPS, however if it is low then it is riskier. However, shareholders can leverage or de-leverage themselves.

Question 12

Why could a company’s capital structure be irrelevant?

Answer 12

Because shareholders can leverage (by taking out loans) or de-lever themselves (selling shares and then lending money)

Question 13

What is Modigliani and Miller’s (M&M) Proposition 1?

Answer 13

that the value of the firm is independent of the firm’s capital structure.

Question 14

What is the two pie model of M&M Proposition 1?

Answer 14

The size of the pie doesn’t depend on how it is sliced.

Question 15

What is M&M Proposition 2?

3 things it depends on?

and formula?

Answer 15

that a firm’s cost of equity capital is a positive linear function of the firm’s capital structure.

which tells us that the cost of equity depends on three things: the required rate of return on the firm’s assets, RA; the firm’s cost of debt, RD; and the firm’s debt-equity ratio, D/E

RE = RA + (RA - RD) x (D/E)

Question 16

What is business vs financial risk?

Answer 16

Business Risk = Risk that comes from the nature of the firm’s operating activities (assets and operations)

Financial Risk = Equity risk that comes from the financial policy (capital structure/leverage) of the firm. Usually introducing by increasing debt as the required return on equity rises. (financial activities)

Question 17

What is EBIT?

Answer 17

Earnings before Interest and Taxes

Question 18

What is the interest tax shield?

Answer 18

Tax saving from interest expense (i.e. interest/coupon payment on bonds x corporate tax rate)

Question 19

If we consider only the effect of taxes, what is the optimal capital structure?

Answer 19

100% Debt

Question 20

What is the relationship between the value of an unlevered firm (Vu) and the value of a levered firm (Vl) once we consider the effect of corporate taxes (Tc)?

Answer 20

Value of levered firm (Vl) = Value of unlevered firm (Vu) + Interest tax shield (Corporate tax rate (Tc) * Total Debt (D))

Question 21

What are direct bankruptcy costs? Examples?

Answer 21

Costs that are directly associated with bankruptcy i.e. legal and administrative expenses

Question 22

What are indirect bankruptcy costs? What are these also referred to as?

Why can these be so costly?

Answer 22

Costs of avoiding a bankruptcy filing incurred by a financially distressed firm. Includes financial distress costs which are direct and indirect costs associated with going bankrupt or experiencing financial distress.

Stakeholders control firm until it is bankrupt so it is in their interest to prevent firms going bankrupt, and vice versa with Bondholders. It causes battles and a vicious cycle of management focusing on managing this instead of running the business.

Examples: loss of sales due to loss of confidence in product as company is in distress. Loss of good staff.

Question 23

What is the Static Theory of Capital Structure and what does it assume?

Answer 23

Firm will borrow up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress.

Assumes the assets and operations of a business are static.

Question 24

What is the trade-off that defines the static theory of capital structure?

Answer 24

There is a benefit for taxes when leveraging or using debt up until the point where the risk of bankruptcy and financial distress starts detracting from the firms value. This effect is also realised and is inverted to WACC

Question 25

What are important factors in making capital structure decisions? i.e. When would you consider leveraging debt (taxes vs financial distress)

Answer 25

Taxes: If you are a firm who pays little taxes or already have heavy depreciation, there will be little benefit to leveraging debt. If you pay a high level of tax then it will benefit to leverage debt.

Fiancial distress: If you are a firm who has liquid assets then you are likely to be able to consider a higher ratio of debt. Alternatively, if your EBIT is unstable (fluctuates a lot) then it is riskier.

Question 26

What is the extended pie model?

Answer 26

Value of all claims against the firm’s cash flows is not affected by capital structure, but the relative values of claims change as the amount of debt financing is increased. i.e. High financial leverage, increase in bondholder claim and bankruptcy claim, decrease in tax claim.

Low financial leverage, decrease in bondholder claim and bankruptcy claim, increase in tax claim.

Trade-offs between bondholder & bankruptcy vs tax and shareholder

Question 27

What are marketed claims vs nonmarketed claims?

Answer 27

Marketed claims can be bought on the market i.e shares and bonds vs Nonmarketed claims cannot, i.e. taxes and bankruptcy costs.

Total value (Vt) = Marketed claims (Vm) + Nonmarketed claims (Vn)

Marketed claims may be affected by changes in capital structure. Thus the optimal capital structure is to maximise value of marketed claims, while minimising value of nonmarketed claims.

Question 28

What is financial slack?

Answer 28

Usually when a business keeps cash reserves to finance projects internally and quickly. (avoiding having to take out debt or sell equity)

Question 29

Under the packing-order theory, what is the order in which firms will obtain financing?

Answer 29

Internal funding first i.e. cash reserves (financial slack)

Debt

Equity (as it can signal overvalued shares)

Question 30

When is pecking order theory likely to be used over static theory?

Answer 30

Depends on the type of organisation, however pecking order theory could be used in the short term to avoid selling equity (then reducing share value) vs Static theory in the long run to leverage tax shields and financial distress.

Question 31

What are some differences in implications of static and pecking-order theories?

Answer 31

No target capital structure in pecking order theory. Capital structure determined by need for external financing.

Profitable firms use less debt because they have greater internal cash flow. This is an observed pattern.

Companies will want financial slack and cash reserves, to avoid selling new equity and so they remain agile when projects need to be executed quickly.

Question 32

What regularities do we observe in capital structures?

Answer 32

That US corporations rely heavily on debt financing

AND

Companies tend to be influenced by their industries debt/equity ratios.

Question 33

What is the difference between liquidation and reorganisation?

Answer 33

Liquidation is when a company sells off its assets (before it dies)

Reorganisations are structural changes i.e. wage cuts and downsizing in order for the company (to survive).

Whether an organisation is liquidated or reorganised depends on whether there is more value if the organisation is dead or alive.