lecture 8: leverage and capital structure

Question 1

capital structure of a firm

Answer 1

the amount of debt and equity making up its asset base

Question 2

why is the capital structure decision referred as the debt-capacity decision?

Answer 2

because it involves a consideration of how much debt a firm should have

Question 3

Indifference EBIT

Answer 3

the EBIT at which EPS with debt financing is equal to EPS with equity financing

Question 4

in the Indifference EBIT, when is leverage beneficial?

why?

Answer 4

when EBIT is expected to increase

because it increases the return to shareholders in term of EPS

Question 5

M&M (Modigliani and Miller) proposition

Answer 5

Unlevered value = Levered value = Levered Equity + Levered debt = EBIT / (unlevered cost of equity)

Vu = VL = EL + DL = EBIT / Reu

Reu: unlevered cost of equity

Question 6

M&M (Modigliani and Miller) proposition assumptions

Answer 6

individuals can borrow or lend at the same market value of interest as firms

no bankruptcy costs

no transaction costs

np inside information

no corporate takes

Question 7

how do we find the cost of equity using the M&M (Modigliani and Miller) proposition?

what can we conclude from this

Answer 7

Re = RA + (RA - RD) · D/E

RA: Wacc

we can conclude:

a) market price of a firm is independent of its capital structures
b) the higher the D/E, the higher the Re that reflects addition risk burned by equity holders

or

Re = ((EBIT) · (1 - Tc)) / Eu

Question 8

where does the M&M proposition way of finding our cost of equity come from?

what does this do to our Equity Beta?

Answer 8

from the SML

Equity beta (BE) = BA · (1 + D/E)

–> risk premium of a firms equity increase alongside the D/E ratio

BA: Asset beta

BE: Equity beta

Question 9

M&M proposition with taxes

VL formula

Answer 9

VL = Vu + (I · Tc) / i

I = annual interest payments

Tc = corporate tax rate

I: interest on debt

but since I = i · D

VL = Vu + Tc · D

–> Tc · D: market premium levered shares, which makes these higher than that of unlevered firms

Question 10

why is it the, the greater proportion of debt in the capital structure, the greater the value of the firm?

M&M proposition with taxes

Answer 10

VL = Vu + Tc · D

Tc · D: market premium levered shares, which makes these higher than that of unlevered firms

Question 11

cost of equity with the M&M proposition with taxes

Answer 11

Re = RA + (RA - RD) · D/E · (1 - Tc)

Question 12

what is the ultimate risk when the D/E of a firm rises?

Answer 12

the firm could fail to meet its payments

Question 13

when is a firm considered economically bankrupt?

Answer 13

when the value of the assets are equal to its debt

Question 14

what is the trade for a firm’s capital structure?

what is the name of this trade off

Answer 14

trade off between the tax benefit of debt and the costs of financial distress

static trade-off theory

Question 15

the implication of the static trade-off theory

Answer 15

there an optimal amount of debt for any individual firm

–> becomes the targeted debt level

Question 16

Value of firm when considering distress costs and bankruptcy?

Answer 16

V = D + E + G + L

V = VM + VN

D + E = VM: Marketed claim

G + L = VN: non-marketed claim

G: government’s claim on the value of the firm for taxes owed

L. the claim by lawyers and other parties involved in the bankruptcy

Question 17

when does a firm become insolvent?

Answer 17

when it experiences financial distress

Question 18

when does a firm experience financial distress?

Answer 18

when it cannot generate enough cash flows to pay off its obligations

Question 19

signs that point at an insolvent firm

Answer 19

reduction or total elimination of dividends

plant clsoings

massive layouts

CEO resignaitons

plummeting stock prices+

etc

Question 20

how can a firm deal with permanent financial distress

Answer 20

selling major assets

drastically reducing or curtailing capital spending and R&D

negotiating with major creditors

exchanging equity for debt (financial restructuring)

filing for bankruptcy

Question 21

the points that indidvade a point has hit the point of no return, where it can no longer exist in its current form

Answer 21

exchanging equity for debt (financial restructuring)

filing for bankruptcy

Question 22

2 ways to define insolvency

Answer 22

stock based insolvency

flow based insolvency

Question 23

stock based insolvency

Answer 23

when a firm has negative net worth

–> value of assets less than debt

–> negative equity

Question 24

flow based insolvency

Answer 24

firm is unable to meet all its contractual obligations such as interests and principal payments

Question 25

when a firm declares bankruptcy and liquidation, the proceeds of the asset selling go in which order?

Answer 25

1. unpaid taxes and employment insurance premiums
2. secured creditors
3. administrative expenses associated with bankruptcy
4. wages salaries, commissions
5. municipal tax claims
6. rent
7. unsecured creditors
8. preferred shares
9. common shares

Question 26

reorganization

Answer 26

option of keeping the firm as a going concern

using new securities to replace the old one

Question 27

the amount stockholders receive yearly including personal tax

Answer 27

(EBIT - D · RD) · (1 - Tc) · (1 - Te)

RD: cost of debt

TC: corporate tax rate

Te: combined dividend and capital gain tax rate

Question 28

the amount bondholders receive yearly including personal tax

Answer 28

D · RD · (1 - Td)

Td: tax rate on ordinary income such as interest

Question 29

total cash flow stockholders and bondholders receive yearly

Answer 29

(EBIT - D · RD) · (1 - Tc) · (1 - Te) + D · RD · (1 - Td)

Question 30

value of a levered firm with all taxes involved

Answer 30

VL = Vu + D · ((1 - ((1 - Tc) · (1 - Te)) / (1 - Td))

Question 31

if Td = Tc, is the value of a firm with or no personal tax bigger?

what happens if Td > Tc

Answer 31

none, they are the same

if Td > Tc, the the value of a firm with no personal tax is bigger than the one with personal tax

Question 32

formula to find which level of EBIT would make the issue of bonds than the issue of shares

indifference EBIT formula

Answer 32

((EBIT - I) · (1 - Tc)) / (# of shares outstanding with bonds issued)

=

((EBIT - I) · (1 - Tc)) / (# of shares outstanding with more shares issued)

Question 33

how to find the cost of equity of an unlevered firm considering taxes

Answer 33

((EBIT - I) · (1 - Tc)) / Total equity

Question 34

how to find the cost of equity of an levered firm considering taxes

Answer 34

((EBIT - I) · (1 - Tc)) / (Value of levered firm - debt)