WEEK 7 - Debt Financing

Question 1

What is a firm’s capital structure?

Answer 1

a firm’s mix of debt and equity financing

Question 2

What is Financial Leverage?

Answer 2

the use of debt, as an attempt to increase the returns to equity.

Question 3

How do firms use leverage to increase stock returns?

Answer 3

the firm borrows and invests in assets that have a rate of return greater than the interest on the loan (effectively, +NPV)

Meaning, real value of firm increases (value of equity too)

Question 4

What is Miller and Modigliani’s response in using capital structure to maximise value of the firm?

Answer 4

-The financial manager
should stop worrying

-In a perfect market, any combination of securities
is as good as another.

-The value of the firm is unaffected by its choice of capital structure.

Question 5

What is the first proposition to the Miller-Modigliani view of maximising mkt value?

Answer 5

Proposition 1:
The market value of any firm is independent of its capital structure.

Instead Firm value determined by real assets, not proportions of debt and equity securities issued to buy the assets

Question 6

SEE EXAMPLE OF INTUITION OF MILLER-MODIGLIANI PROPOSITION 1 IN NOTES (JUST TO UNDERSTAND THE PROPOSITION AND THINGS OCCUR BECAUSE OF IT)

Answer 6

SEE IN NOTES

Question 7

What is an unlevered and levered firm?

Answer 7

Unlevered:
- No debt so value of equity equal to value of firm

Levered:
- Value of equity equal to value of firm minus value of its debt

Question 8

Why is it that a firm’s market value is independent of its capital structure? (Proposition 1)

Answer 8

Due to absence of arbitrage opportunities, if two investment opportunities offer the same return then they must equal the same

Question 9

What does Proposition 1 of the MM model assume?

Answer 9

• Competitive markets: individuals can borrow and lend at the same rate; individuals can borrow at the same interest rate as firms
• Efficient markets: complete and symmetric information
  there are no arbitrage opportunities.
• Absence of taxation
• Absence of bankruptcy costs
• Investment opportunities unaffected by financing decisions

Question 10

What are the calculations to remember for an unlevered firm?

Answer 10

• Operating Income = Equity Income
• Return on shares = EPS/Price
• Earnings per share =
  Operating Income / No of shares

Question 11

What are the calculations to remember for a levered firm?

Answer 11

Interest = Interest rate x Value of debt
Equity Earnings = Operating Income - Interest
EPS = Equity Earnings / No of shares
Return on Shares = EPS/Price

Question 12

Under proposition 1 of the MM model what therefore changes if the firm does decide to borrow?

Answer 12

• If firm goes and borrows, nothing changes in terms of abilities of the investor (Not increase value)
• Return on equity changes not overall return on assets

Question 13

Under Proposition 1 of the MM model why does leverage increase the expected stream of earnings per share but not the share price?

Answer 13

the change in the expected earnings stream is exactly offset by a change in the rate at which the earnings are discounted.

Question 14

How do we calculate the expected return on the company’s assets? (ra)

Answer 14

ra = Expected Operating Income / Mkt value of all securities

Question 15

How do we find the expected return on a portfolio consisting of all the firm’s securities?

Answer 15

As company’s borrowing decision does not affect either the firm’s operating income or the total market value of its securities.
↓↓
Borrowing decision also does not affect the expected return
on the company’s assets (rA).

If the investor holds all of a company’s debt (D) and all of its equity (E) → he is entitled to all the firm’s operating income

→the expected return on the portfolio is just rA.
So rA will be equal to a weighted average of the expected returns on the individual holdings. In turn giving us expected return on a portfolio of all the firm’s securities

Question 16

What is the Expected Return on a portfolio consisting of all the firm’s securities?

Answer 16

ra = E/ E + D Re + D/E+D Rd

Where Re = Expected return on equity
Rd = Expected return on debt

Question 17

What is the Weighted Average Cost of Capital (WACC)

Answer 17

Same as the expected return on a portfolio consisting of all the firm’s securities

Ra = E/ E+D Re + D/E+D Rd

Question 18

How do we represent MM’s second propsition mathemematically?

Answer 18

Solve the above eqaulity for re we get:

Re = Ra = (Ra - Rd) D/E

Question 19

What is MM’s second proposition?

Answer 19

The expected rate of return on the common stock of a levered firm increases in proportion to the market value of the debt-equity ratio (D/E ). The rate of increase depends on the spread between the expected return on all the firm’s securities/assets (rA) and the return on debt (rD ).

Question 20

What is the first implication of MM’s Proposition 2?

Answer 20

What matters is the operating income (or cash flows) and the overall market value of our financial assets.
The composition of our financial assets (i.e., the capital structure) is irrelevant.

Question 21

What is the second implication of MM’s proposition 2?

Answer 21

Leverage only creates a positive spread between the expected return on equity (or common stock) and the (weighted) expected return of financial assets.
Remember: 𝑟𝐸=𝑟𝐴+(𝑟𝐴−𝑟𝐷) 𝐷/𝐸
notice that when D =0, then rE = rA;
as long as D >0 , then rE > rA;
it is not rA that has changed, but… only rE has increased

Question 22

What is the general summary of MM’s two propositions?

Answer 22

MM’s proposition I says that financial leverage has no effect on shareholders’ wealth.
MM proposition II says that the rate of return they can expect to receive on their shares increases as the firm’s debt-equity ratio increases

Question 23

can shareholders be indifferent to increased leverage when it increases expected return?

Answer 23

any increase in expected return is exactly offset by an increase in risk and, therefore, in shareholders’ required rate of return.

Question 24

What would happen if the firm issued an additional 20 of debt and used the cash to repurchase 20 of its equity?

Answer 24

The change in financial structure does not affect the amount or risk of the cash flows on the total portfolio of debt and equity.

Therefore, if investors required a return of 9% on the total portfolio before the refinancing, they must require a 9% return on the firm’s assets afterward.
Leverage has no effect on the cost of capital!

Question 25

SEE EXERCISE TO CALCULATE THE WAAC IN LECTURE SLIDES

Answer 25

SEE IN NOTES

Question 26

What happens to the indiviudal securities if the firm issues additional debt to repurchase their shares

Answer 26

Although the required return on the portfolio of debt and equity is unaffected, the change in financial structure does affect the required return on the individual
securities.

Leverage affects the calculation of the cost of capital, because it affects the information in equity and debt returns.

Question 27

Suppose that the company decided instead to repay all its debt and to replace it with equity. What would happen to rA and rE ?

Answer 27

In that case all the cash flows would go to the equity holders. The company cost of capital, rA, would stay at 9%, and rE would also be 9%.

Question 28

What are the implications of MM’s propositions for returns?

Answer 28

The expected return on equity increases linearly with the
debt-equity so long as debt is risk-free.
But if leverage increases the debt risk, debtholders
demand a higher return on debt.
This causes the rate of increase in rE to slow down

SEE GRAPH IN NOTES

Question 29

What are the implications of MM’s propositions for returns? (CONT.)

Answer 29

• > As the firm borrows more, the risk of default increases and the firm is required to pay higher rates of interest.
• > Proposition II predicts that when this occurs the rate of increase in rE slows down.

->The more debt the firm has,
the less sensitive rE is to further borrowing.

Question 30

Why does the slope of the re line decrease as D/E increases?

Answer 30

Because holders of risky debt bear some of firm’s financial risk.

As the firm borrows more, more of that risk is transferred from stockholders to bondholders.

Question 31

What does the MM model ignore and is therefore challenged on?

Answer 31

MM ignored taxation

- ceteris paribus as debt increases the after-tax WACC falls

Question 32

How do you calculate the after tax WACC?

Answer 32

WACC (After tax) = Ta = E/E +D Re + D/E+D Rd (1-Tc)

Where:

• The after tax cost of debt is rd (1-Tc)
• Tc is corporate tax rate

Question 33

What does MM’s proposition 2 state happens in the absence of taxes?

Answer 33

Proposition 2 states in absence of taxes the company WACC stays the same regardless of amount of leverage
- If companies receive tax shield on interest payments, then after-tax WACC declines as debt increases

Question 34

How does debt create a tax shield for levered firms?

Answer 34

because it reduces taxable income

Question 35

How do you calculate the interest payment and tax shield?

Answer 35

Interest Payment = D x Rd

Tax deduction equal to:
Tax shield = Interest payment x Corporate Tax rate
= Tc x D x Rd