Lesson 9: Capital Structure

Question 1

Capital structure

Answer 1

the combination of debt and equity that a company uses to finance its project is called the capital structure of the company

Question 2

if a project is financed purely with equity, the equity is said to be

Answer 2

unlevered

Question 3

Proposition 1 (Modigliani-Miller I)

Answer 3

In a perfect capital market, the value of a company’s securities depends only on the market value of its future cash flow. Capital structure does not affect the value
(A perfect capital market follows 3 conditions:
+ investors and firms can trade securities at competitive market prices based on future cash flows
+ Transactions are efficient: no taxes, transaction costs, insurance costs
+ A company’s method of financing does not affect its future cash flows from the project, nor does it provide info about the company)

Question 4

Homemade leverage

Answer 4

the leverage created = an investors
Let D: company’s debt, E: company’s equity. Enterprise value = D + E, you prefer debt to be a different proportion, you can take the following steps:
1. Buy x of the company’s equity -> your proportion of the enterprise value = x(D+E)/E
2. You want the proportion of debt financing to be r -> you want your portion of the debt = rx(D+E)/E, currently it is xD/E -> borrow the difference: x(r(D+E) - D)/E, if that number is (-) -> lend
3. Scale your investment in equity or debt up or down to the desired level

Question 5

Leveraged recapitalization

Answer 5

A company borrows money in order to repurchase its shares

Question 6

Proposition 2 (Modigliani-Miller II)

Answer 6

The cost of levered equity increases with the debt-equity ratio D/E
rE = rU + D(rU - rD) / E (rE: cost of equity capital)

Question 7

pretax weighted cost of capital or pretax WACC

Answer 7

is defined as the unlevered cost of capital or rU + D(rU - rD) / E

Question 8

Debt-to-value ratio

Answer 8

D/(D+E)