LM 6: Capital Structure

Question 1

What is the after-tax cost of debt rate?

Answer 1

rd* (1-t)

rd = rate to borrow debt
t = tax rate

Question 2

What is the weighted average cost of capital formula and if you can’t determine the target weight what can you use?

Answer 2

WACC = wdrd (1-t) + were

wd = target weight of debt
rd = rate to borrow debt
t = tax rate
we = target weight of equity
re = rate to borrow equity

use percentage of total market value for weights.

Question 3

When should a company accept a project when using NPV or IRR vs WACC?

Answer 3

accept if positive NPV using the WACC required rate of return

accept if IRR > WACC

Question 4

What are capital-light businesses vs capital intensive?

Answer 4

capital light: business with minimal working capital needs (the need for debt) and often high cash flows even in the early stage

capital-intensive: businesses (e.g., real estate, utilities, airlines) require a substantial asset base in order to operate

Question 5

At what life cycle stage would debt financing not be available?

Answer 5

early stage/ startup

too risky for lenders and if available it would be at high interest rates that the company can’t afford

Question 6

What does the capital structure for companies in the growth stage consist of?

Answer 6

equity is the primary source of capital

limited use of debt, if debt usually secured by assets

Question 7

What does the capital structure for companies in the mature stage consist of?

Answer 7

the company can support its own but can use both debt and equity financing

Question 8

What is the operating leverage formula?

Answer 8

operating leverage = % change in operating income/ % change in sales (revenue)

Question 9

What is the interest coverage ratio formula?

Answer 9

interest coverage = operating profit (EBIT) / interest payments

Question 10

What are the 3 types of assets that affects a companies business model, and the 2 sub categories?

Answer 10

1. Tangibility assets
   - tangible
   -intangible
2. Fungibility assets
   -non fungible (unique)
   -fungible (interchanged equally eg. $100 for $100)
3. Liquidity assets
   - illiquid
   -liquid

Question 11

What is the difference between a subscription based business model and a one at a time purchase business model?

Answer 11

subscription based models: revenues very stable & not sensitive to overall economy

one at a time purchase: revenues volatile and fluctuates with the economy

Question 12

What are the 2 type of asset ownership?

Answer 12

1. self-ownership
2. outsourced to third parties (asset light eg. uber)

Question 13

What are third party debt ratings?

Answer 13

Larger companies pay at least one third-party agency (e.g., Moody’s, Fitch) to rate individual debt issues and provide an assessment of their overall creditworthiness.

Question 14

What are the 5 assumptions under the modigliani-miller proposition 1? ICITF

Answer 14

1. Investors have homogeneous expectations: investors agree on expected cash flows from an investment.
2. Capital markets are perfect: no transaction costs, no taxes, and no bankruptcy costs. Everyone has access to the same information.
3. Investors can borrow & lend at the risk-free rate.
4. There are no agency costs: Managers always act in the best interest of the investors, maximizing shareholder wealth.
5. Financing and investment decisions are independent.

Question 15

What is an unlevered firm?

Answer 15

firm with no debt and fully financed with equity

Question 16

What is MM proposition 1 without taxes and formula?

Answer 16

VL=VU+tD

Vl = value of levered firm
Vu = value of unlevered firm
tD = tax shield

Question 17

What is the static trade off theory of capital structure?

Answer 17

the optimal capital structure exists and is determined by the achievement of balance between tax benefits and costs of debt

Question 18

What is the difference between book value and market value?

Answer 18

book value is the amount of money shareholders would receive if assets were liquidated and liabilities paid off.

market value is the value of a company according to the markets based on the current stock price and the number of outstanding shares.

Question 19

Why would investors need to estimate WACC for a company?

Answer 19

because target weights are typically only known to insiders

Question 20

What is pecking order theory, and the 3 orders ?

Answer 20

pecking order theory states that managers display the following preference of sources to fund investment opportunities

1. through the company’s retained earnings
2. followed by debt
3. choosing equity financing as a last resort.

Question 21

What is agency costs?

Answer 21

incremental costs that arise from conflicts of interest between managers, shareholders, and bond holders

Question 22

What does jensens free cash flow hypothesis state?

Answer 22

states that taking on more financial leverage disciplines managers by leaving them with less cash to use unwisely.

Question 23

What is the formula for value of a leveraged firm?

Answer 23

Vl = Vu + (tax rate * debt) - PV (cost of financial distress)

Question 24

What is Modigliani and Miller’s Proposition II with taxes and without taxes?

Answer 24

with taxes: cost of equity increases as company increases amount of debt in capital

without taxes: The cost of equity is a linear function to the debt to equity ratio

Question 25

How would you maximize value of a firm?

Answer 25

by adopting the capital structure with the lowest weighted-average cost of capital

Question 26

What is Modigliani and Miller’s Proposition I with taxes and without taxes?

Answer 26

with taxes: a levered company’s market value is equal to the value of an unlevered company plus the value of the debt tax shield. VL = VU + TD

without taxes: market value of company is not affected by capital structure of company. VL = VU

Question 27

What is weight of debt formula?

Answer 27

debt market value/ total market value of equity and debt