Topic 8: Financial Strategy and Capital Structure

Question 1

Is there an optimal capital structure?

Answer 1

Yes - that which gives the lowest cost of capital; which gives the highest possible enterprise value; which gives the highest possible equity value

Question 2

provided that ROA > Kd; increased leverage….xxx EPS and ROE.
Conversely…

Answer 2

Provided that ROA > Kd; increased leverage INCREASES EPS and ROE
Converse is also true
Therefore introducing gearing magnifies variability in profit and thus EPS & ROE.

Question 3

Assumptions to M&M models (8)
(in general: 
- perfect capital markets
- no information asymmetry
- all CFs are level perpetuities
- no agency problems

Answer 3

1. capital mkts are frictionless
2. investors can borrow & lend at Rf rate
3. there are no costs to bankruptcy
4. firms issue only 2 types of claims: rf & equity
   5 no taxes
5. all CF are perpetual
6. no signalling
7. mgrs. always maximise shareholder wealth

Question 4

Modigliani/Miller Proposition #1 WITHOUT TAX:

Modigliani/Miller Proposition #1 WITH TAX:
& implications for WACC

Answer 4

WITHOUT TAX; value of levered firm is the same as a firm funded entirely by equity
V(L) = V(U) = OFCF / rho
Arbitrage will drive V(L) to V(U)

WITH TAX: V(L) = V(U) + T(c)D (where T(c)D measures PV(ITS) where all CFs are level perps
Without tax, WACC was constant. With tax, WACC must DECREASE with leverage

Question 5

Modigliani/Miller Proposition #2

• increasing leverage…
• formula

Answer 5

• increasing leverage increases the variability of ROE and thus increases the risk carried by firm’s equity holders
• formula: R(e) = rho + (rho - R(d)) * D/E
• any move away from zero debt increases the risk to equity holders, so they require compensation by way of a higher rate of return

Question 6

MM Proposition 1 & 2 (no tax) lead to:

WACC remains constant with increasing debt - why?

Answer 6

WACC remains constant with increasing debt because :
if cost of equity rises linearly from rho; then any benefit from using lower cost debt is offset by increased cost of equity.
Rising cost of equity exactly offsets the rising cost of debt so that WACC remains constant

Question 7

Limits to the use of debt, given that MM implies 100% debt is value adding:

Answer 7

1. Ability to use tax deductions on interest (ie timing - need to fund losses before tax benefit is gained)
2. cost of financial distress - impact and move to possible bankruptcy (legal, admin, liquidation)
3. indirect costs of financial distress: higher funding costs/limited debt facilities; loss of sales due to doubts on warranties; employees; tax credits; can’t pursue growth options; weaker finl position; conflicts S/H vs debt holders

Question 8

Agency Costs of equity (conflict between original manager and equity holders) (4)

Answer 8

1. manager may not work as hard as cannot claim 100% of CF (shared w/ S/H)
2. cost of perqs not solely borne by mgr. Costs of monitoring
3. pursuit of investments (increase firm size, or diversify risks) rather than returning cash to S/H
4. less inclined to pursue operational perf improvements
   Costs tend to be lower when a large portion of stock is held by managers; and the greater the reliance on debt finance

Question 9

Agency costs of debt

Answer 9

1. incentive to undertake high risk projects
2. incentive to under invest
3. incentive to milk the assets

Question 10

Signalling models

Answer 10

• mgr’s willingness to take on debt is interpreted as a signal of confidence on outlook
• dividend signalling - may signal asymmetric info

Question 11

Pecking order model

Answer 11

ordering for decisions:

1. prefer to use retained earnings first
2. then debt finance
3. then new equity (least preferred)

Question 12

Financial flexibility (5)

Answer 12

• maintain cash balances above operational; requirements
  2. maintain reserve borrowing capacity (ie not borrowing to max level)
  3. maintain committed debt facilities such as revolving credit
  4. Set dividend policy at levels that can be maintained on a LT basis
  5. Maintain hurdle rates in excess of cost of capital partly in order to screen marginal projects thus saving financial capacity

Question 13

Cap structure decisions:

- Financial distress costs (5)

Answer 13

1. higher expected financial distress costs -> lower debt ratios
2. prob of financial distress = fn of risk of firm’s CF
3. cost of financial distress is greater for smaller firms
4. Cost is least for those with tangible assets that can be sold
5. value of intangible assets largely disappears in bankruptcy situation

Question 14

Cap structure decisions:

- tax position of firm (2)

Answer 14

1. profitable firms should borrow to take advantage of tax shield
2. uncertainty about ability to utilise tax shields implies low debt ratios

Question 15

Cap structure decisions:

• asset type
• agency costs of equity
• flexibility

Answer 15

• asset type
  If V(L) is mainly growth opps; low debt.
• agency costs of equity
  if agency costs of equity are a risk, then firm will benefit from increased debt eg high levels of CF rel to growth opps; or products with low competition
• flexibility
  if significant growth opps exist, choose conservative financial structure for the flexibility
  issuing external equity increases # of people to be kept happy. Debt is temporary and can be paid off.