Topic 9 - Capital Structure

Question 1

Capital Structure

Answer 1

the proportions of debt, equity and other securities that a firm has outstanding

Question 2

Unlevered equity

Answer 2

equity in a firm with no debt

Question 3

levered equity

Answer 3

this refers to having an ownership stake in a company that uses debt financing in its capital structure. when a company takes on debt it is levered because debt amplifys potential risk and potential return for equity holders

Question 4

rWACC formula

Answer 4

rWACC =
(D / D+E) x rD + (E / D+E) x rE

Question 5

is debt or equity cheaper

Answer 5

debt. however it raises the cost of capital for equity

Question 6

MM proposition 1

Answer 6

In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.

Question 7

home made leverage

Answer 7

When investors use leverage in their portfolios to adjust the leverage choice made by the firm.
if investors want a different capital structure than the one the firm has chosen they can borrow or lend om their own to achieve the same result.

Question 8

MM proposition 2

Answer 8

This explains the relationship between a firms cost of capital, its leverage, and the risk of its assets.
The cost of capital of levered equity is the same as the cost of capital of unlevered equity plus a premium that is proportional to the market value debt to equity ratio

Question 9

MM1 Formula

Answer 9

V^L = V^U

Question 10

MM2 Formula

Answer 10

rE = rU + D/E (rU - rD)

Question 11

interest tax shield + formula

Answer 11

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

Tax Shield = Corporate tax rate x interest payment

Question 12

MM1 formula with tax

Answer 12

MM1 states that leverage increases a firms value due to the tax deductibility of interest payments. contrasting the original MM1 proposition.

V^L = V^U + PV (interest tax shield)

Question 13

MM2 formula with tax

Answer 13

rE = rU + D/E (rU - rD) x (1 - Tc)

Question 14

how does tax change company value

Answer 14

it reduces company value because some of it goes towards tax collectors. When we include debt in capital structure we pay interest which is tax deductible, which means we create a tax shield.

Question 15

Trade-off theory

Answer 15

The firm picks its capital structure by trading off the benefits of the tax shield from debt against the cost of financial distress.
according to trade-off theory, the total value of a levered firm is the value of the firm without leverage plus the present value of the tax savings from debt capital, less the present value of financial distress costs

Question 16

Trade off theory formula

Answer 16

V^L = V^U + PV(tax shield) - PV(Financial distress costs)

Question 17

why not only use debt if we can avoid tax?

Answer 17

because the risk of bankruptcy is much higher if we only use debt capital. there is an optimal level of debt that should be used

Question 18

pecking order hypothesis

Answer 18

managers will prefer to fund investments by first using retained earnings, then debt and equity only as a last resort

Question 19

adverse selection

Answer 19

when one party in a transaction has better information than the other. this results in higher quality participants being driven out of the market by the lower quality ones.

Question 20

how does adverse selection work (insurance example)

Answer 20

health insurance providers can’t perfectly assess the health of potential customers. people with higher health risks are more likely to buy insurance while healthier people may opt out due to higher premiums based on average risk.
the result of this is that the pool of insured people becomes disproportional riskier, driving premiums higher.