Lecture 7

Question 1

The Pie Theory and its Implications

Answer 1

• The proportions of debt financing and equity financing is called the capital structure of a firm
• The value of the firm (pie) consists of both debt and equity
• The goal of a firms management is to make the firm as valuable as possible

Question 2

Levered Vs Unlevered Firms

Answer 2

Levered = Financed by debt and equity
Unlevered = Financed by equity only

Question 3

MM Proporsition 1

Answer 3

A firm cannot change the total value of its outstanding securities by only changing the capital structure (without taken on extra finance)

Question 4

MM Proporistion 2

Answer 4

• The size of the the pie is set, it doesn’t matter how toy slice it
• It states that the required return to shareholders (cost of equity) rises with leverage

Question 5

MM Proporistions (assumptions and limitations)

Answer 5

Assumptions
- No taxes
- No transaction costs
- Individuals and corporations borrow at the same rate
Limitations
- The assumptions are too for away from realistic

Question 6

What is the Cost of Capital

Answer 6

• The expected return available on alternative investments in the market with comparable risk and return

Question 7

Cost of capital (equity vs debt)

Answer 7

• 100% equity financed - cost of capital is equal to the cost of equity
• 100% debt financed - cost of capital is equal to the cost of debt
• Financed by both debt and equity - it’s cost of capital can be derived from cost of equity and cost of debt along with the proportions of equity and debt

Question 8

Cost of debt

Answer 8

• For high rating debt ( A and above ) the yield of the debt is the cost of debt
• For low rating debt ( A and below ) the cost of debt can be calculated by either debt yields or default equation

Question 9

Cost of capital for a firm financed by both debt and equity

Answer 9

Can be worked out in two ways:
- Unlevered cost of capital ( if we ignore corp tax)
- WAAC ( if we consider corp tax)