Reading 26- Capital Structure

Question 1

What is the objective of a company’s capital structure decision?

***Critical Concept******

Answer 1

To determine the optimal proportion of debt and equity financing that will minimize the firm’s WACC

**This will maximize the value of the firm.

Question 2

Explain MM Proposition I (No Taxes) …..

***Critical Concept******

Answer 2

Capital structure is irrelevant; the value of the firm is unaffected by the capital structure

V_L = V_U

Question 3

Explain MM Proposition II (No Taxes) ……

***Critical Concept******

Answer 3

The cost of equity increases linearly as a company increases its proportion of debt financing.

The benefits from using more debt are exactly offset by a rise in the cost of equity, resulting in no change to a firm’s WACC

Question 4

Explain MM Proposition I (With Taxes) …..

***Critical Concept******

Answer 4

Value is maximized at 100% debt, the tax shield provided by debt causes the WACC to decline as leverage increases.

V_L = V_U + (t * d)

Question 5

Explain MM Proposition II (With Taxes) …..

***Critical Concept******

Answer 5

WACC is minimzed at 100% debt, the tax shield provided by debt causes the WACC to decline as leverage increases.

Question 6

What is the Cost of financial distress?

Answer 6

The increased costs companies face when earnings decline and the company has trouble paying its interest costs.

Question 7

What are the 2 components of the expected costs of financial distress for a firm ?

Answer 7

1. Direct and indirect costs of financial distress and bankruptcy
2. Probability of financial distress

Question 8

What are the net agency costs of equity?

Answer 8

The costs asociated with the conflict of interest between a company’s manager and owners

There are 3 components.

Question 9

What are 3 components of the net agency costs of equity ?

Answer 9

1. Monitoring costs
2. Bonding costs
3. Residual losses

Question 10

What are the costs of asymmetric information?

Answer 10

This is when managers have more information about a firm than investors.

Question 11

What is the pecking order theory?

***Critical Concept******

Answer 11

States that managers prefer financing choices that send the least visible signal to investors, with internal capital being most preferred , debt being next , and raising equity externally the least preferred method of financing

Internal Capital > Debt > External Equity

Question 12

What is the Static trade-off theory ?

***Critical Concept******

Answer 12

States that managers will try to balance the benefits of debt with the costs of financial distress.

***There is an optimal capital structure that has an optimal proportion of debt.

Question 13

What is the formula to calculate the value of a levered firm that has costs of financial distress ?

***Critical Concept******

Answer 13

V_L = V_U + (t * d) - PV(Cost of financial distress)

Question 14

What are some factors an analyst should consider when evaluating a firm’s capital structure?

Answer 14

1. Changes in the firm’s capital structure over time
2. Capital structure of competitors with similar business risk.
3. Factors affecting agency costs such as the quality of corporate governance

Question 15

What are the major factors that influence international differences in financial leverage ?

Answer 15

1. Institutional, legal, and taxation factors
2. Financial market and banking system factors
3. Macroeconomic factors

Question 16

What are the 5 simplifying assumptions of the Modigliani Miller (MM) study?

***Critical Concept******

Answer 16

1. Capital Markets are perfectly competitive
2. Investors have homogenous expectations
3. Riskless borrowing and lending exists
4. No agency costs - i.e. conflict between shareholders and managers
5. Investment decisions are unaffected by financing decisions

Question 17

How do you solve for the cost of equity from the WACC formula, assuming the marginal tax rate is 0?

Answer 17

Question 18

How do you solve for the cost of equity from the WACC formula, assuming the marginal tax rate is != 0?

Answer 18

Question 19

What is the ultimate conclusion of the Modigliani and Miller theory?

***Critical Concept******

Answer 19

It demonstrates that managers cannot create value simply by changing the company’s capital structure.