R15: Capital Structure

Question 1

Modigliani-Miller

Answer 1

-under certain assumptions, a company’s choice of capital structure does not affect its value.

Question 2

Proposition 1 (without taxes)

Answer 2

• Capital structure irrelevance
• the market value of the company is not affected by the structure
• wacc is not affected by capital structure
• determined solely by cash flows

Question 3

Proposition 2 (without taxes)

Answer 3

• Higher financial leverage raises the cost of equity
• increases in cost of equity are offset by greater use of lower cost debt
• cost of equity is linear function of D/E

Question 4

MM proposition with taxes

Answer 4

• debt provides a tax shield

- results in savings that enhance the value of the firm (value increases with increasing debt)

Question 5

Agency cost

Answer 5

Agency costs are the costs associated with the fact that all public companies and the larger private companies are managed by non-owners. Agency costs are the incremental costs arising from conflicts of interest when an agent makes decisions for a principal.