Lesson 9: Capital Structure

Question 1

What does it mean if a project is unlevered?

Answer 1

A project is financed purely with equity, otherwise it is levered.

Question 2

What is the capital structure of a company?

Answer 2

The combination of debt and equity that a company used to finance its projects.

Question 3

What is Modigliani-Miller’s proposition 1?

Answer 3

In a perfect capital market, the value of a company’s securities depends only on the market value of its future cash flows. Capital structure does not affect the value.

Question 4

What three conditions are satisfied by a perfect capital market?

Answer 4

1. Investors and firms can trade securities at competitive market prices based on future cash flows.
2. Transactions are efficient. There are no taxes,transaction costs, or insurance costs.
3. A company’s method of financing does not affect future cash flows from the project, nor does it provide information about the company.

Question 5

What is homemade leverage?

Answer 5

The leverage created by an investor. Individual investors can borrow or lend at the same interest rate as the company, so an individual can be as levered as the company.

Question 6

What is Modigliani-Miller’s 2nd proposition?

Answer 6

The cost of unlevered equity capital increases with the debt-equity ratio D/E