Perfect Capital Market Flashcards
What are the three assumptions of a Perfect Capital Market?
1) Capital markets are perfectly competitive
Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.
2) Capital markets are frictionless.
There are no taxes, transaction costs, or issuance costs associated with security trading.
3) Financing and investment decisions are independent of each other
A firm’s financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them.
What is MM First Proposition?
The total value of a firm’s securities is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.
The pie may be sliced in different ways, but its total size will remain unchanged.
Since the size of the pie remains the same, the present value of the company’s expected future cash flows remains the same. This means the future cash flows are unaffected by changes in capital structure.
You are given the following information about two companies:
Company A and Company B have identical assets that generate identical cash flows.
Company A is an all-equity firm. It has 5 million shares outstanding and the current price for a share of stock is $20.
Company B has 10 million shares outstanding and the current price for a share of stock is $10. It also has a debt of $50 million.
Assess whether MM Proposition I holds. If the proposition does not hold, determine the transactions to exploit the arbitrage opportunity.
A
MM Proposition I does hold.
B
MM Proposition I does not hold. To exploit the arbitrage opportunity, buy 1 share of Company A, sell 2 shares of Company B, and borrow $10.
C
MM Proposition I does not hold. To exploit the arbitrage opportunity, buy 1 share of Company A, sell 2 shares of Company B, and lend $10.
D
MM Proposition I does not hold. To exploit the arbitrage opportunity, sell 1 share of Company A, buy 2 shares of Company B, and borrow $10.
E
MM Proposition I does not hold. To exploit the arbitrage opportunity, sell 1 share of Company A, buy 2 shares of Company B, and lend $10.
B
MM Proposition I does not hold. To exploit the arbitrage opportunity, buy 1 share of Company A, sell 2 shares of Company B, and borrow $10
Since both companies have identical assets that generate identical cash flows, MM Proposition I argues that both companies must have the same value regardless of their financing choices.
Company A:
EquityADebtAFirmA=(5m)⋅($20)=$100m=0=EquityA+DebtA=$100m+0=$100m
Company B:
EquityBDebtBFirmB=(10m)⋅($10)=$100m=$50m=EquityB+DebtB=$100m+$50m=$150m
Since the values of the two companies are not the same, MM Proposition I does not hold, and thus an arbitrage opportunity exists.
To exploit the arbitrage opportunity, we will use the two-step approach.
Step 1. Using an inequality, write down what you observe. In this case, the value of Company B is greater than the value of Company A:
FirmB>FirmA
Step 2. Move everything to the greater-than side.
FirmB−FirmA >0 DebtB+EquityB−EquityA >0 $50m+ (10m)⋅Stock B −(5m)⋅Stock A >0 $10+2⋅Stock B −1⋅SA>0 The terms in the resulting inequality indicate the cash flows needed to exploit the arbitrage. A positive sign represents a cash inflow; a negative sign means a cash outflow.
Thus, in order to exploit the arbitrage, engage in the following transactions:
borrow $10
sell 2 shares of Company B
buy 1 share of Company A
What is Modigliani-Miller Proposition II ?
Modigliani-Miller Proposition II states that the cost of capital of levered equity increases with the firm’s debt-to-equity ratio.
d/e increase: r equity increase
According to Modigliani and Miller Proposition I, with perfect capital markets:
A
The value of a company is independent of its capital structure.
B
The cost of equity increases as the use of debt in the capital structure increases.
C
Managers can increase the value of the company by employing tax saving strategies.
D
Managers can change the value of the company using more or less debt.
E
Bankruptcy risk increases with more leverage.
A
The value of a company is independent of its capital structure
Determine which of the following statements about Modigliani and Miller propositions in a perfect capital market is FALSE.
A
If investors would prefer an alternative capital structure to the one the firm has chosen, investors can borrow or lend on their own and achieve the same result.
B
As long as investors can borrow or lend at the same interest rate as the firm, homemade leverage is a perfect substitute for the use of leverage by the firm.
C
With perfect capital markets, because different choices of capital structure offer no benefit to investors, they do not affect the value of the firm.
D
A firm’s WACC increases with the firm’s market value debt-equity ratio.
E
With perfect capital markets, a firm’s WACC is independent of its capital structure and is equal to its equity cost of capital if it is unlevered, which matches the cost of capital of its assets.
D
A firm’s WACC increases with the firm’s market value debt-equity ratio.
Determine which of the following statements about the effect of increasing the amount of leverage in a firm’s capital structure in a perfect capital market is FALSE.
A
With no debt, the WACC is equal to the unlevered equity cost of capital.
B
As the firm borrows at the low cost of capital for debt, its equity cost of capital rises, but the firm’s WACC remains unchanged.
C
As the amount of debt increases, the debt cost of capital also rises.
D
With 100% debt, the debt would be as risky as the assets themselves.
E
As the debt and equity costs of capital both rise when leverage is high, the WACC rises as well.
C
As the amount of debt increases, the debt cost of capital also rises.
You are given:
rD denotes the cost of debt for a firm
τC denotes the marginal corporate tax rate for the firm
Which of the following statements is/are TRUE?
I ) The interest tax deduction reduces the effective cost of debt from rD to (1−τC)rD.
II) For every $1 in new permanent debt that the firm issues, the value of the firm increases by 1−τC.
III) The tax deductibility of interest payments reduces the weighted average cost of capital by τCrD.
Statement I is true.
Without taxes, the effective cost of debt is rD.
With taxes, the effective cost of debt is rD(1−τC).
Statement II is false.
The PV of the interest tax shield for a permanent debt is τC⋅D.
This formula shows the magnitude of the interest tax shield. For every $1 in new permanent debt that the firm issues, the value of the firm increases by τC⋅$1=$τC.
Statement III is false.
The firm’s effective after-tax WACC, or simply the WACC, measures the required return to the firm’s investors after taking into account the benefit of the interest tax shield:
rWACC=wE⋅rE+wD⋅rD⋅(1−τC)=wE⋅rE+wD⋅rDPre-tax WACC−wD⋅rD⋅τCInterest tax shield
Thus, the tax deductibility of interest payments reduces the weighted average cost of capital by wD⋅rD⋅τC.
Determine which of the following statements about the capital structure in a perfect capital market is FALSE.
A
Even with perfect capital markets, leverage would affect a firm’s value.
B
Leverage increases the risk of the equity of a firm.
C
Leverage increases the risk of equity even when there is no risk that the firm will default.
D
A risk-free debt has a risk premium of zero.
E
Promised payments to debt holders must be made before any payments to equity holders are distributed.
A
Even with perfect capital markets, leverage would affect a firm’s value.
Statement A is false.
In a perfect capital market, financing and investment decisions are independent of each other. A firm’s financing decisions do not change the cash flows generated by its investments.
Thus, the firm’s capital structure is irrelevant. Changing a firm’s capital structure merely changes how the value of its assets is divided between debt and equity, but not the firm’s total value.
Statements B and C are true.
Modigliani-Miller Proposition II states that the cost of capital of levered equity increases with the firm’s debt-to-equity ratio. This is true even when there is no risk that the firm will default.
Statement D is true.
A risk-free debt has a beta of zero:
βD=0
Using the CAPM, we can see that:
E[RD]=rf+βD(E[RMkt]−rf)=rf+0=rf
Thus, the risk premium is:
E[RD]−rf=rf−rf=0
Statement E is true.
Debt holders have a priority claim on assets and income above equity holders. Debt holders must be paid first before any payments to equity holders are distributed.
