Week 4 - Does debt policy matter? (Capital structure I)

Question 1

Leverage ratio

Debt-market ratio

FYI, capital structure = debt = equity

Answer 1

Leverage ratio
= Debt / assets
= Debt / (debt + equity)

Debt-market ratio
= Debt / market value of equity

Question 2

Unlevered vs Levered

Return on equity (%)

Answer 2

1. Unlevered - no debt, all-equity financed
2. Levered (more debt) - BORROWS money and uses the borrowed money to REPURCHASE shares at market value
   *LEVERAGE INCREASES RISK!!!

Return on equity
= Operating income / Market value of shares
= EPS / Price per share

Question 3

2 ways to reason why leverage is more risky

Answer 3

1. Leverage CONCENTRATES RISK of assets amongst a smaller no. of shareholders.
   - {b/c firm has bought back some shares so smaller no. of shares outstanding}
   - Shareholders are exposed to BUSINESS RISK (risk of ASSETS)
2. Debt holders get the best, first cash flows. Equity holders get the leftover CFs.

Question 4

2 effects of leverage – trade-off for equity holders

Answer 4

1. Increases shareholders’ expected EPS & expected ROE, as long as firm’s expected Rate of RETURN that > interest payment rate (COST OF DEBT)
2. But also increases RISK of EQUITY (even when debt is risk-free)
   - through the STEEPNESS of line of EPS vs Operating income graph

ie. EPS is more SENSITIVE to changes in operating income when there’s leveraging.

Question 5

MM’s capital structure irrelevance - what it means & the 6 conditions

^MM Proposition I

Answer 5

Under PERFECT CAPITAL MARKETS, firm value & shareholder wealth do not change when firms change capital structure

6. NO BANKRUPTCY COSTS
7. Investment is held constant
8. No transaction costs
9. Efficient capital markets
10. Managers maximise shareholders’ wealth
11. No taxes (or, no differential tax treatment between equity & debt)

MM’s theorem applies regardless whether debt is RISK-FREE or RISKY.
^total CFs going to investors are unchanged

Question 6

MM Proposition I - intuition for individual investors

Answer 6

In perfect capital markets, individuals can borrow/lend just as easily as firms & don’t need the firm to borrow for them, can BORROW on their OWN ACCOUNT & INVEST in unlevered firm’s equity to REPLICATE the levered firm’s earnings
- can create HOMEMADE LEVERAGE
- so will not pay more to invest in an otherwise identical levered firm, since if firms borrow, make equities riskier.

Question 7

How is business/operating risk shared between equity- and debt holders for risk-free vs risky debt?

Answer 7

1. With risk-free debt, debtholders are completely shielded from business risk, so ENTIRE operating risk is borne by equity holders
2. When risky debt, operating risk of assets is SHARED between equity- and debt holders.

Question 8

Company cost of capital aka
(pre-tax) Weighted average cost of capital (WACC)

2 ways of presenting formula
*similar for CAPM beta form

^MM Proposition II

Answer 8

Represents the AVERAGE rate of return investors expect to earn by holding all securities of the firm.

1. rE = rU + D/E(rU - rD)
2. rA = rU = (D/D+E)rD + (E/D+E)rE

MM Proposition II: The expected rate of return on the common stock of a LEVERED firm increases in PROPORTION to the debt-equity ratio (D/E)

> Any increase in expected return is exactly offset by an increase in risk. Hence why leverage does not affect value

Question 9

Hidden cost of debt

Answer 9

= The fact that debt makes equity riskier.
- EXTRA FINANCIAL RISK UNDOES THE CHEAPNESS OF DEBT
- So overall firm’s cost of capital stays the same, ie. rA is fixed

Question 10

Summary of MM Propositions I and II - Financial leverage…
1. Does not affect __
2. Does affect __
3. May affect __?

Answer 10

1. Does NOT affect
   - risk or expected return on firm’s assets
   - firm value
2. Does affect
   - risk & expected return on firm’s common STOCK
3. May affect
   - risk & expected return on DEBT, depending on the amt of leverage & nature of the default
   (risk-free vs risky?)

Question 11

If a firm is delevering (replacing debt by issuing new equity), what can a shareholder do to undo the effect of this decision & ensure that you are entitled to exactly the same profits as before?

ref. to Ms Kraft example

Answer 11

Relever own portfolio by borrowing to buy additional shares
1. Calculate __% stake of equity in the firm, ie. no. of shares you hold / total no. of shares outstanding
2. Borrow __% * value of debt = xx
3. Purchase xx/share price = __ additional shares