OE - Advanced Capital Structure and Firm Value Flashcards

1
Q

How do you measure the value added to a firm by taking on leverage?

A

Value added = (tax rate) x (debt issued)

From V levered = V unlevered + TcD

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2
Q

A company is looking to raise funds. What do you advise them to do and what is your thinking?

A

A company can raise debt or equity funds depending on its current capital structure, credit rating, and growth potential. If a company isn’t highly levered, you could advise them to issue debt, since that’s the cheapest way of financing. If management believes that their stock is overvalued, you could advise them to issue equity. If management believes that the upside to the stock price is limited, you could advise them to issue convertible bonds.

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3
Q

Explain the Modigliani - Miller (M&M) capital structure theorems without taxes.

A

The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that in absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed or what the firm’s dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance principle.

Proposition I: Capital structure is irrelevant to the value of the firm:

You cannot increase the value by rearranging the value of the firm; payout will always be the same.

Proposition II: A higher debt-to-equity ratio leads to a higher required return on equity because of the higher risk involved for equity-holders in a company with debt. The formula is derived from the theory of weighted average cost of capital:

Ke = Ko + D/E(Ko - Kd)

Ke is the required rate of return on equity, or cost of equity
Ko is the cost of capital for an all-equity firm
Kd is the required rate of return on borrowings, or cost of debt
D/E is the debt to equity ratio

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4
Q

Under which economic environment would it be good to issue convertible bonds?

A

An ideal environment would be when management believes there is limited upside in their stock price; therefore, after a market rally. Management would be able to take advantage of the lower interest rate that convertible debt carries vs. straight debt, while at the same time potentially avoid the dilution of existing shareholders if the convertible option was exercised.

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5
Q

Which is cheaper for an issuer, a zero-coupon bond or convertible bond? Which would minimize interest payments / conserve cash flow?

A

A zero-coupon bond would be cheaper, since it is pure debt. A convertible bond is effectively a combination of debt and equity, so since the cost of equity is higher than the cost of debt, then it follows that the convertible bond would be more costly. A zero-coupon bond doesn’t have interest payments, which would conserve cash flow until the maturity date.

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6
Q

You have a company with $200mm in assets, $100mm in debt, and -$100mm in equity. Would you pay $50mm for it?

A

Trick question. Book value of equity does not necessarily have any relevance to the market value of equity (not true for FIG companies).

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7
Q

What is an alternative to declaring dividends?

A

Stock buybacks, which have the added benefits of not being expected to recur and allow investors to take the taxes (upon sale of the shares) whenever they choose.

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