Week 6- The Capital Structure Decision Flashcards
What does WACC stand for?
Weighted Average Cost of Capital
The terms required return, appropriate discount rate, and cost of capital differ how?
They do not, they mean essentially the same thing.
What does it mean if the required return on investment is 10%?
If the required return on an investment is 10%, we mean the investment will have a positive NPV only if its return exceeds
10%, which is the cost of capital associated with investment.
How can a firm raise capital?
- Debt by borrowing (either through banks or a bond
- Issuing equity
When is the value of the firm maximised?
When the WACC is minimised
What does a debt-equity ratio that results in the lowest WACC represent?
The optimal capital structure
Why is giving someone equity riskier than taking n debt?
As they are they are the residual owner, in case of bankruptcy you pay debt holder before equity holders. Additionally giving away equity is more volatile; the returns are unknown, whereas debt is generally known (ie the interest)
What is the WACC formula?
WACC = Ke(E/(E+D)) + Kd(D/(E+D)) * (1-Tc)
where:
𝑇𝑐 stands for the corporate tax rate.
𝐾𝑒 is the cost of equity.
𝐾𝑑 is the cost of debt.
𝐸 is the value of equity.
𝐷 is the value of debt.
𝐸/(𝐸+𝐷) & 𝐷/(𝐸+𝐷) represent the weights of equity and debt
Why can extra debt be preferable within the capital structure?
As debt is tax deductible
What is the value of the firm calculated by?
Value = Estimate of future cash flows/WACC
Why is WACC used in the regulatory process?
To determine what is a “fair” level of profit.
Why do companies calculate their WACC?
- As an overall measure of company performance linked to shareholder wealth.
- To use as an input in investment appraisal method.
What does financial leverage concern?
The proportion of debt in its capital structure
What does capital leverage focus on?
Capital leverage focuses on the extent to which a firm’s total capital is in the form of debt. The more debt financing a firm uses
in its capital structure, the more financial leverage it employs
How does capital structure affect financial risk?
If operating profits are high, the geared firm’s shareholders will experience a more than proportional boost in their returns compared to the ungeared firm’s shareholders.
What does geared mean?
Just another term for leveraged
Although firms with leverage operated have higher returns than those without, what is also true about them?
They have higher standard deviations (ie higher risk)
What is business risk?
Business risk is the risk associated with a company’s profits and earnings varying due to systematic influences on that company’s business sector.
What does financial risk relate to?
Financial risk is the volatility of distributable profits arising from the need to meet interest payments, which will get progressively higher as a company’s gearing level increases.
How do we calculate financial risk?
Total Risk- Business Risk = Financial Risk
Why does borrowing reduce net income?
As interest payments are required
Why does borrowing increase EPS?
As there’s less need to issue additional equity, so there are less shares
Why does a firm borrowing increase risk for shareholders?
As there is increased volatility in the net income
What are the 4 kinds of risk a firm undergoes?
Risk-Free Rate
Business Risk
Financial Risk
Bankruptcy Risk
Does the WACC increase with higher debt levels?
Yes
What does Modigliani and Miller’s (1958) Proposition 1 state (assuming no corporate tax)
“The market value of any firm is independent
of its capital structure” and that the total market value of the firm is the NPV of its income stream V = C1/WACC
Why in Modigliani and Miller (1958) is the WACC constant?
Because the cost of equity capital rises to exactly offset the effect of cheaper debt.
What are Modigliani and Miller’s (1958) assumptions?
- There is no taxation
- There are perfect capital markets, with perfect information available to all economic agents and no transaction costs
- There are no costs of financial distress and liquidation
- Firms can be classified into distinct risk classes
- Individuals can borrow as cheaply as corporations
What does Modigliani and Miller’s (1958) Proposition 2 state (without taxes)?
“The expected rate of return on the common stock of a levered firm ↑ in proportion to the debt-equity ratio (D/E).”
How do we calculate the expected return on equity of a geared firm?
𝑟𝐸 = 𝑟𝐴 + 𝐷/𝐸 (𝑟𝐴 − 𝑟𝐷)
Why is adding in the market imperfection of corporate tax a crucial feature of M&M’s 1963 paper. What features does debt have?
- Interest paid on debt is tax-deductible
- Failure to meet debt obligations can result in bankruptcy
What is the tax savings called when interest is deductible for tax purposes?
The interest tax shield
How do we calculate the present value of the interest tax shield?
Present value of the interest tax shield = 𝑇c × 𝐷
What does Modigliani and Miller’s (1958) Proposition 1 state (with corporate tax)
M&M Proposition I with taxes states that: 𝑉𝐿 = 𝑉𝑈 + (𝑇𝐶 × 𝐷). This implies that the value of a levered firm will be maximized if it becomes
100% debt financed - ↑ 𝐷 →↑ 𝑉𝐿.
What does Modigliani and Miller’s (1958) Proposition 2 state about the return on equity (without taxes)?
𝑟𝐸 = 𝑟𝐴 + 𝐷/𝐸 (𝑟𝐴 − 𝑟𝐷) × (1 − 𝑇𝑐)
M&M Propositions with taxes implies that the value of a levered firm will be maximized if it becomes 100% debt financed - ↑𝐷 →↑ 𝑉𝐿. Why is this incorrect?
- Personal taxes should also be considered – maybe personal taxation and corporate taxation offset each other thus influencing the PV of the corporate tax shield.
- The key is that borrowers incur costs – bankruptcy and agency costs, which offset the PV of the interest tax shield.
When does financial distress occur?
Financial distress occurs when a firm has difficulty in meeting its contractual obligations. An extreme example would be where the firm defaults on its obligations and enters bankruptcy.
Why is the financial distress important?
- To the extent that financial distress is related to leverage, the key assumption underlying the MM proposition I is violated – capital structure matters for reasons other than taxes.
- Investors know that levered firms may fall into financial distress – this is thus reflected in the current value of the firm
When taking financial distress into account, how can a firm be valued?
Value of firm = Value if all equity financed + {PV(tax shield) – PV(costs of financial distress)}
What are the bankruptcy costs associated with financial distress?
- Direct costs, legal and administrative, such as court fees
- Indirect costs reflecting the difficulty of managing a company undergoing liquidation or reorganization.
What are other non-bankruptcy related costs associated with financial distress?
- Conflicts of interest between shareholders and bondholders– can result in poor operating and investment decisions.
- Stockholders can operate in their own self-interest and gain at the expense of creditors by playing games→↓value of the firm.
- Debt contracts should prevent such games – but requires cost of writing, monitoring and enforcing the debt contract.
What does the traditional approach state? Does this happen in reality?
- Under the traditional approach, a degree of financial leverage may increase expected equity returns, although not to the degree predicted by M&M proposition II.
- Firms that borrow moderately find that 𝑟𝐸 ↑ but < than predicted by MM.
- Excessive borrowing ↑ 𝑟𝐸 but > than predicted by MM → a ↓ in the WACC (𝑟𝐴 ) at first then ↑.
How does asset beta express the effect of leverage on the risk of a firm’s securities?
𝛽𝐴 = 𝛽D(E/(E+D)) + 𝛽E(D/(E+D))
How do we find the risk on equity for a leveraged firm?
𝛽𝐸 = 𝛽𝐴 + 𝐷/𝐸 (𝛽𝐴 − 𝛽𝐷)
