Lesson 3: Capital Structure

Question 1

Why do we care about a firm’s capital structure decision?

Answer 1

1. Leverage can increase profitability, but also risk
2. Capital structure impacts firm value

Question 2

What is Modigliani & Miller (M&M)’s capital structure “irrelevence” theory? Why is it important?

Answer 2

1. Showed if certain assumptions hold, the choice of capital structure won’t change the firm’s value
2. Showed us how debt can matter

Question 3

What are the assumptions of M&M’s theory?

Answer 3

1. No taxes
2. No costs of financial distress / bankruptcy
3. Method of financing has no impact on the firm’s investment decisions
4. Capital markets are “fair” (all investors have same information, and capital always available at “fair” prices)

Question 4

What is the reason the capital structure decision, through the tax shield benefit of debt, can have an effect on the value of the firms?

Answer 4

Because interest expense is paid out of pre-tax income, while dividends are paid out of after-tax income

Question 5

What is the optimal capital structure?

Answer 5

A structure that balances out the benefits of debt (mainly associated with the tax shield benefit of debt) with the costs associated with financial distress and bankruptcy.

Question 6

The capital structure of a firm refers to:

Answer 6

The mixture of debt and equity used by the firm to finance its assets

Question 7

In a world with taxes, the value of a firm is measured by:

Answer 7

It’s payout → which increases with debt bc of benefits of tax shield