LT Lecture 4 - Debt Policy

Question 1

Debt vs equity

Answer 1

Question 2

Formula of Leverage Ration

Answer 2

Leverage ratio: Debt / Asset = Debt / (Debt+Equity)

Question 3

Effect of leverage

Answer 3

• Changing leverage does change the return, but not the firm value.
• Higher return but higher risk

Question 4

Plot earnings per share (EPS) against operating income with and without leverage

Answer 4

Question 5

6 assumptions of Modigliani-Miller Theorem (Debt policy)

Answer 5

Question 6

Problem of “Irrelevance of Capital Structure”

(Rewrite question)

Answer 6

Question 7

Replication:

Levered to Unlevered

Answer 7

Question 8

Replication:
From Unlevered to Levered

Answer 8

Question 9

Explain Capital Structure Irrelevance

Answer 9

Question 10

Formula of WACC

Answer 10

Question 11

Explain:

The expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity ratio (D/E)

the return to equity of the levered firm

(Rewrite)

Answer 11

Question 12

Plot WACC on:

r against D/E

Answer 12

Question 13

If CAPM is true, returns are linearly related to betas.

State the formulas

Answer 13

Question 14

Explain WACC on risky debts + graph

Answer 14

• When debt is risky, higher leverage increases the required return on debt.
• Higher return on debt lowers return on equity.
• So rE line initially goes up and then goes down
• When rD = rA, WACC gives that rE = rA too!
• So three curves rE, rD, and rA converges.

Question 15

After-tax WACC formula and graph

Answer 15

Question 16

Adjusted Present Value

Answer 16

Question 17

1) Financing side effect
2) Cost of financial distress

of adjusted present value

Answer 17

Question 18

Trade-off theory

Answer 18