Lecture 8: Debt Policy and Capital Structure Flashcards
What is the primary goal of financial managers?
the primary goal of financial managers is to Maximize stockholder wealth by maximizing-increasing firm value
What is capital structure?
Capital structure refers to the mixture of debt and equity
What is an Unlevered Firm?
Unlevered Firm (VU) : A firm without leverage (e.g., no debt) in its capital structure, or an all-equity financed firm.
What is a levered Firm?
Levered Firm (VL) : A firm with leverage (e.g., debt) in its capital structure
What does the Modigliani and Miller Proposition 1 (without taxes) state?
Modigliani and Miller Proposition 1 (without taxes) states that:
“ The market value of the company is not affected by its capital structure”
What is the capital structure irrelevance principle?
Modigliani and Miller Proposition 1 (without taxes) states that:
“ The market value of the company is not affected by its capital structure”
This is also known as the capital structure irrelevance principle
Firm value is independent from the choice of capital structure
Any combination of securities (debt or equity) is as good as another
The financial manager should not worry about the choice of capital structure but rather, focusing on which projects to undertake
Separation between financing and investment decisions
what does the Modigliani & Miller 1 (without taxes) suggest?
M & M 1 suggests that no matter how the firm is financed, its market value (or the market value of its assets) will not change
e.g a compnay with 100 assets o debt and 100 equaity si worth the same as a levered firm with 80 debt 20 equity and 100 assets
What does Modigliani & Miller 2 (without taxes) state?
Modigliani & Miller Proposition 2 (without taxes) states that:
“The cost of equity of a levered firm, Rle , increases in proportion to the debt to equity ratio (D/E).”
First note that equity is always riskier than debt
Debt holders are getting paid a promised amount but no guarantees to equity holders
Higher levels of debt means higher financial risk for equity holders
Equity holders must require higher return for higher levels of debt
what are the assumptions of the Modigliani & Miller Theorems Under Taxes?
Modigliani & Miller Theorems Under Taxes.
Interest expense is tax deductible
Therefore, when a firm adds debt, it reduces tax liability
The reduction in tax liability increases cash flow to all investors
Modigliani & Miller Proposition 1 (with taxes) states what?
Modigliani & Miller Proposition 1 (with taxes) states that:
The value of a levered firm is equal to the value of an unlevered firm plus the present value of interest tax shields.”
Modigliani and Miller Proposition 2 (with taxes) states what?
Modigliani and Miller Proposition 2 (with taxes) states that:
“The cost of equity of a levered firm, 𝑟_𝑒^𝐿, increases in proportion to the debt-to-equity ratio (D/E).”
What are the main costs of bankruptcy?
Direct Cost:
Lawyer fees
Court fees
Other administration fees
Indirect Cost:
Loss of customers
Time spend in bankruptcy proceedings
Goodwill of the company
what is the trade off theory?
Trade-Off Theory
At low debt levels, tax shields outweigh bankruptcy costs thus firm value increases
As the firm borrows more, bankruptcy costs increase substantially
So, there is a trade off between tax shields and bankruptcy costs as the company borrows more.
There must be a point where the marginal benefit from tax shields is offset by the marginal cost of bankruptcy
That point is the optimal capital structure where firm value is maximized
