Session 1: Debt Policies

Question 1

How does Modigliani & Miller feel about the value of a firm?

Answer 1

Modigliani & Miller believe that with perfect capital markets, the total value of a firm should not depend on how its financed.

Question 2

What are the 3 Assumptions of Modigliani and Miller?

Answer 2

1. the market is efficiently priced
2. there are no taxes, transaction costs, or issuance costs associated with trading
3. a firm’s financing decisions doesn’t change cash flows generated by its investments

Question 3

Acquisition of Debt or Equity is cheaper and why?

Answer 3

The acquisition of debt is cheaper since it is less risky

Question 4

Modigliani-Miller Proposition I Without Taxes

Answer 4

In a perfect capital market, the total value of a firm equals the market value of the total cash flows generated by its assets and is NOT affected by its choice of capital structure

Question 5

Define Leverage Recapitalization

Answer 5

a firm uses borrowed funds to pay a large special dividend or to repurchase a significant amount of outstanding shares to reduce equity

Question 6

Modigliani-Miller Proposition II Without Taxes

Answer 6

The cost of capital of levered equity is equal to the cost of capital of unlevered equity PLUS a premium that’s proportional to the market value debt-equity ratio

Question 7

What is WACC?

Answer 7

The Weighted Average Cost of Capital

Question 8

How is WACC without taxes calculated?

Answer 8

rWACC = E / E + D * rE + D / E+D * rD

Question 9

What does Beta measure?

Answer 9

The effect of leverage on the risk of a firm’s securities

Question 10

What is Net Debt?

Answer 10

Net Debt = Debt - Cash & Risk Free Securities

Question 11

Define Dilution

Answer 11

An increase in the total of shares which will divide a fixed amt of earnings

Question 12

What causes dilution?

Answer 12

Share offerings

Question 13

What causes stock prices to decrease when a share offering is announced?

Answer 13

dilution of ownership, signaling effect, supply & demand dynamics, use of proceeds, and short-term focus

Question 14

Define Interest Tax Shield

Answer 14

the reduction in taxes paid due to the tax deductibility of interest

Question 15

How is Interest Tax Shield calculated?

Answer 15

Interest Tax Shield = Corporate Tax Rate * Interest Payments

Question 16

How is WACC with taxes calculated?

Answer 16

rWACC = E / E + D * rE + D / E+D * rD * 1-tc

Question 17

What is the Tradeoff Theory?

Answer 17

a concept that explains how companies determine their optimal capital structure by balancing costs and benefits of debt and equity financing. It suggests that firms strive to reach a balance where the marginal cost of debt equals its marginal benefit.

Question 18

What are the key components of the Tradeoff Theory?

Answer 18

1. Benefits of debt
2. Costs of debt
3. Optimal capital structure

Question 19

Define Asymmetric Information

Answer 19

when two parties have different information

Question 20

Define Adverse Selection

Answer 20

when buyers and sellers have different information, the average quality of assets in the market will be lower than the average quality overall

Question 21

Define Lemons Principle

Answer 21

when a seller has private information about the value of a good, buyers will discount the price they’re willing to pay due to adverse selection

Question 22

A firm selling new shares demonstrates what?

Answer 22

A negative signal that perhaps their value is poor

Question 23

If managers perceive the firm’s equity is underpriced, what will they do?

Answer 23

they will have a preference to fund investments using retained earnings rather than equity

Question 24

What is the bottom line?

Answer 24

the optimal capital structure depends on market imperfections