Topic 8- Debt Policy and Optimal Capital Structure

Question 1

What are the 2 main benefits of debt?

Answer 1

• Tax benefits

- Adds discipline to management

Question 2

What are the 3 main costs of debt?

Answer 2

• Bankruptcy costs
• Agency costs
• Loss of future flexibility

Question 3

What are the tax benefits of debt?

Answer 3

When you borrow money, you’re allowed to deduct interest expenses from your income to arrive at taxable income; this reduces your taxes

Question 4

What is proposition 1?

Answer 4

The higher the marginal tax rate of a business, the more debt it will have in its capital structure

Question 5

How does debt add discipline to management?

Answer 5

Managers of firms with no debt, which generate high income and cash flows each year, tend to become complacent leading to inefficiency and investments in poor projects. Forcing such a firm to borrow money can be an antidote to the complacency as the managers now have to ensure that the investments they make will earn at least enough return to cover interest expenses

Question 6

What are the 2 main factors affecting a firms expected bankruptcy costs?

Answer 6

• The probability of bankruptcy

- The cost of going bankrupt: direct and indirect costs

Question 7

What are the direct costs of bankruptcy?

Answer 7

Legal and other deadweight costs

Question 8

What are the indirect costs of bankruptcy?

Answer 8

Costs arising because people perceive you to be in financial trouble

Question 9

What is proposition 2?

Answer 9

Firms with more volatile earnings and cash flows will have higher probabilities of bankruptcy at any given level of debt and for any given level of earnings

Question 10

What is proposition 3?

Answer 10

Other things being equal, the greater the indirect bankruptcy cost, the less debt the firm can afford to use for any given level of debt

Question 11

What is the formula for a firm’s overall market value?

Answer 11

Value if all equity financed + PV tax shield - PV costs of financial distress

Question 12

What are agency costs?

Answer 12

When you lend money to a business, you are allowing the stockholders to use that money in the course of running that business. Shareholders interests are different from tour interests because you as a lender are interested in getting your money back and stockholders are interested in maximising their wealth

Question 13

What 2 things can the clash of interests from agency costs result in shareholders doing?

Answer 13

• Investing in riskier projects than you would want them to

- Paying themselves large dividends when you would rather have them keep the cash in the business

Question 14

What is proposition 4?

Answer 14

Ceteris paribus, the grater the agency problems associated with lending to a firm, the less debt the frim can afford to use

Question 15

What happens when a firm borrows up to its capacity?

Answer 15

It loses the flexibility of financing future projects with debt

Question 16

What is proposition 5?

Answer 16

Ceteris paribus, the more uncertain a firm is about its future financing requirements and projects, the less debt the firm will use for financing current projects

Question 17

What is the Pecking Order theory?

Answer 17

There is a strict financing hierarchy of: internal funds (cheapest)➡debt➡equity (most expensive)

Question 18

What are the 4 steps to optimal Capital Structure using the Cost of Capital model?

Answer 18

1. Estimate the cost of equity at different levels of debt
2. Estimate the cost of debt at different levels of debt
3. Estimate the Cost of Capital (WACC) at different levels of debt
4. Choose the capital structure that minimises WACC, and evaluate the effect on firm value and stock price

Question 19

What happens to equity as a result of higher debt?

Answer 19

Higher debt➡equity will become riskier➡beta will increase➡cost of equity will increase

Question 20

What happens to debt as a result of higher debt?

Answer 20

Higher debt➡default risk will go up and bond ratings will go down➡cost of debt will increase

Question 21

What is the formula for the value of a firm?

Answer 21

Expected cash flow to firm next year/cost of capital-g

Question 22

What is the formula for unlevered beta?

Answer 22

β_unlevered = β_levered/(1+(1-Tc)D/E)

Question 23

What are the 2 main benefits of reduced leverage?

Answer 23

• Lower cost of equity because equity risk (levered beta) is reduced
• Lower default risk of the bonds

Question 24

What is the formula for cost of debt?

Answer 24

cost of debt = risk free rate + default spread

Question 25

Give 3 main limitations of the Cost of Capital approach

Answer 25

• It is static
• Minimising WACC does not necessarily maximise frim value
• Beta and ratings are based upon rigid assumptions of how market risk and default risk get borne as the firm borrows more money and the resulting costs

Question 26

What 3 other variables is the cost of capital for a firm equal to, in a tax-free environment?

Answer 26

• Equal to the market value weighted average of the return on equity and the return on debt
• Equal to the r_a , the rate of return for that business risk class
• Equal to the overall rate of return required on the levered firm

Question 27

When does optimal capital structure occur?

Answer 27

When the present value of tax savings on account of additional borrowing just offsets the increase in the present value of costs of distress

Question 28

Is it possible for firms to overcome bankruptcy?

Answer 28

Firms can postpone bankruptcy for many years and may ultimately recover from financial distress and avoid bankruptcy altogether

Question 29

What 2 main things does the pecking order theory imply?

Answer 29

• Firms prefer internal finance

- Firms prefer debt equity when external financing is required