Week 2

Question 1

Ordinary shares vs preference shares:

Answer 1

Preference shares include dividends being paid out to owners before common shareholders. The same goes in terms of bankruptcy.
Preference shares have a low dividend yield and lower voting rights.

Question 2

Dedicated capital and additional paid-in capital:

Answer 2

Dedicated capital = par value of shares * shares outstanding
Additional paid-in capital = (excess value-par value) * shares outstanding
Book value of shares = Equity / Shares Outstanding

Question 3

Shareholder rights:

Answer 3

1) Right to dividends
2) Right to remaining assets after liquidation
3) Right to vote on important matters
4) Pre-emptive right; right to any new equity sold

Question 4

Different types of debt:

Answer 4

1)T-bill - short-term debt with a maturity of less than a year
2) Note - unsecured debt with maturity shorter than a debenture, for example, less than 10 years
3) Debenture - long-term unsecured corporate debt.
4) Bond - long-term debt secured by a mortgage on the corporate property
5) Consol - perpetual debt with no specific maturity date

Question 5

Modigliani and Miller assumption 1:

Answer 5

In case of no taxes and perfect market changes in the capital structure of the company do not change the value. Through the use of homemade leverage, shareholders can upset overpriced levered companies by investing in unlevered ones, and receive the same payoff. Equilibrium will arise and levered companies will fall in value.

V(L)=V(U)
V(U) = Cash flow/R(A)

Key assumption: interest rates for borrowing for shareholders are the same as the company’s. This applies to real life, as brokers hold equity as collateral, providing low-interest rates.

Question 6

Modigliani and Miller assumption 2:

Answer 6

The expected rate of return is positively related to leverage in the company. When a firm has more debt it becomes riskier. Increasing the cost of equity for the company, even though WACC stays constant.

R(A) = WACC = Expected earning to unlevered firm/Unlevered Equity

R(E) = R(A) + D/E * (R(A)-R(D))

Question 7

Tax shield:

Answer 7

TcR(D)D

Annual tax amount the firm will pay less with a debt of D

PV of tax shield is:

Tc*D

A tax shield is an asset, which reduces future tax payments.

Question 8

Value of a levered firm with taxes:

Answer 8

V(L) = V(U)+PV(tax shield) = EBIT(1-Tc)/R(A) + Tc*D

Question 9

Modigliani and Miller assumption 1 (With taxes):

Answer 9

Firms can raise their value by increasing debt due to tax shield.

Question 10

Modigliani and Miller assumption 2 (With taxes):

Answer 10

The cost of equity rises with increased debt financing. Taking taxes into account the formula to calculate R(E) changes to:

R(E) = R(A) + D/E *(1-Tc) * (R(A) - R(D))

Question 11

Personal taxes:

Answer 11

Shareholders pay personal tax on dividends (Te), leaving them with:
(1-Tc)*(1-Te)

Bondholders pay tax on interest payments received, leaving them with:
(1-Td)

Question 12

Disadvantages of shareholder value maximization:

Answer 12

1) Can lead to short-term thinking by managers, due to their limited employment contracts.
2) Ethical considerations.
3) Lobbying - influencing politicians.
4) Certain management bonuses are linked to shareholder value.