Week 6- The Capital Structure Decision

Question 1

What does WACC stand for?

Answer 1

Weighted Average Cost of Capital

Question 2

The terms required return, appropriate discount rate, and cost of capital differ how?

Answer 2

They do not, they mean essentially the same thing.

Question 3

What does it mean if the required return on investment is 10%?

Answer 3

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.

Question 4

How can a firm raise capital?

Answer 4

• Debt by borrowing (either through banks or a bond
• Issuing equity

Question 5

When is the value of the firm maximised?

Answer 5

When the WACC is minimised

Question 6

What does a debt-equity ratio that results in the lowest WACC represent?

Answer 6

The optimal capital structure

Question 7

Why is giving someone equity riskier than taking n debt?

Answer 7

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)

Question 8

What is the WACC formula?

Answer 8

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

Question 9

Why can extra debt be preferable within the capital structure?

Answer 9

As debt is tax deductible

Question 10

What is the value of the firm calculated by?

Answer 10

Value = Estimate of future cash flows/WACC

Question 11

Why is WACC used in the regulatory process?

Answer 11

To determine what is a “fair” level of profit.

Question 12

Why do companies calculate their WACC?

Answer 12

• As an overall measure of company performance linked to shareholder wealth.
• To use as an input in investment appraisal method.

Question 13

What does financial leverage concern?

Answer 13

The proportion of debt in its capital structure

Question 14

What does capital leverage focus on?

Answer 14

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

Question 15

How does capital structure affect financial risk?

Answer 15

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.

Question 16

What does geared mean?

Answer 16

Just another term for leveraged

Question 17

Although firms with leverage operated have higher returns than those without, what is also true about them?

Answer 17

They have higher standard deviations (ie higher risk)

Question 18

What is business risk?

Answer 18

Business risk is the risk associated with a company’s profits and earnings varying due to systematic influences on that company’s business sector.

Question 19

What does financial risk relate to?

Answer 19

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.

Question 20

How do we calculate financial risk?

Answer 20

Total Risk- Business Risk = Financial Risk

Question 21

Why does borrowing reduce net income?

Answer 21

As interest payments are required

Question 22

Why does borrowing increase EPS?

Answer 22

As there’s less need to issue additional equity, so there are less shares

Question 23

Why does a firm borrowing increase risk for shareholders?

Answer 23

As there is increased volatility in the net income

Question 24

What are the 4 kinds of risk a firm undergoes?

Answer 24

Risk-Free Rate
Business Risk
Financial Risk
Bankruptcy Risk

Question 25

Does the WACC increase with higher debt levels?

Answer 25

Yes

Question 26

What does Modigliani and Miller's (1958) Proposition 1 state (assuming no corporate tax)

Answer 26

"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

Question 27

Why in Modigliani and Miller (1958) is the WACC constant?

Answer 27

Because the cost of equity capital rises to exactly offset the effect of cheaper debt.

Question 28

What are Modigliani and Miller's (1958) assumptions?

Answer 28

1. There is no taxation 2. There are perfect capital markets, with perfect information available to all economic agents and no transaction costs 3. There are no costs of financial distress and liquidation 4. Firms can be classified into distinct risk classes 5. Individuals can borrow as cheaply as corporations

Question 29

What does Modigliani and Miller's (1958) Proposition 2 state (without taxes)?

Answer 29

“The expected rate of return on the common stock of a levered firm ↑ in proportion to the debt-equity ratio (D/E).”

Question 30

How do we calculate the expected return on equity of a geared firm?

Answer 30

𝑟𝐸 = 𝑟𝐴 + 𝐷/𝐸 (𝑟𝐴 − 𝑟𝐷)

Question 31

Why is adding in the market imperfection of corporate tax a crucial feature of M&M's 1963 paper. What features does debt have?

Answer 31

- Interest paid on debt is tax-deductible - Failure to meet debt obligations can result in bankruptcy

Question 32

What is the tax savings called when interest is deductible for tax purposes?

Answer 32

The interest tax shield

Question 33

How do we calculate the present value of the interest tax shield?

Answer 33

Present value of the interest tax shield = 𝑇c × 𝐷

Question 34

What does Modigliani and Miller's (1958) Proposition 1 state (with corporate tax)

Answer 34

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.

Question 35

What does Modigliani and Miller's (1958) Proposition 2 state about the return on equity (without taxes)?

Answer 35

𝑟𝐸 = 𝑟𝐴 + 𝐷/𝐸 (𝑟𝐴 − 𝑟𝐷) × (1 − 𝑇𝑐)

Question 36

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?

Answer 36

* 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.

Question 37

When does financial distress occur?

Answer 37

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.

Question 38

Why is the financial distress important?

Answer 38

- 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

Question 39

When taking financial distress into account, how can a firm be valued?

Answer 39

Value of firm = Value if all equity financed + {PV(tax shield) – PV(costs of financial distress)}

Question 40

What are the bankruptcy costs associated with financial distress?

Answer 40

- Direct costs, legal and administrative, such as court fees - Indirect costs reflecting the difficulty of managing a company undergoing liquidation or reorganization.

Question 41

What are other non-bankruptcy related costs associated with financial distress?

Answer 41

* 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.

Question 42

What does the traditional approach state? Does this happen in reality?

Answer 42

* 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 ↑.

Question 43

How does asset beta express the effect of leverage on the risk of a firm's securities?

Answer 43

𝛽𝐴 = 𝛽D*(E/(E+D)) + 𝛽E*(D/(E+D))

Question 44

How do we find the risk on equity for a leveraged firm?

Answer 44

𝛽𝐸 = 𝛽𝐴 + 𝐷/𝐸 (𝛽𝐴 − 𝛽𝐷)