Lesson 6 Capital Structure & Rates of Return

Question 1

Modigliani and Miller believe that operating risks are independent of

Answer 1

financial risks.

Question 2

M&M believe that the value of an un-leveraged firm is equal to the value of a

Answer 2

leveraged firm.

Question 3

What is arbitrage?

Answer 3

Arbitrage is the process of simultaneously buying and selling the same or equivalent securities in different markets to take advantage of temporary price differences.

Question 4

Why do investors use “homemade leverage?”

Answer 4

To adjust their own financial debt-equity structure without cost and control their own returns. This makes investors indifferent about capital structure of the firms they invest in.

Question 5

If you include corporate taxes, why is a levered firm able to allocate less of its cash flow to the payment of taxes?

Answer 5

The tax deductibility of interest.

Question 6

The logical extension of the M&M theory is that

Answer 6

in order to maximize shareholder value, all firms should use high levels of debt financing. (not what we see in practice)

Question 7

Problems with M&M Approach

Answer 7

A firm that uses excess financial leverage may encounter the following problems which will have a direct, negative impact on EV:

Lost business, lost credit, servicing debt instead of operating expenditures, forego growth opportunities because you cannot raise capital

Question 8

M&M model does not take into account which two transaction costs that arise when a firm uses excess debt:

Answer 8

Financial distress costs (expected costs of bankruptcy)
Agency costs (cost of monitoring, restricting covenants)

Question 9

In theory, the optimal capital structure is the mix of debt and equity that maximizes:

Answer 9

enterprise value and minimizes WACC.