Debt Policy

Question 1

Financial Leverage

Answer 1

The uses debt as an attempt to increase the returns to equity.

Question 2

Capital Structure

Answer 2

a firms’ mix of debt and equity financing.

Question 3

Use of 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 and +NPV)- real value of the firm increases

Question 4

Modigliani-Miller approach 1

Answer 4

Imagine that the financial manager would like to find the combination of securities that maximizes the value of the firm. MM’s answer the financial manager should stop worrying.

Question 5

Modigliani-Miller approach 2

Answer 5

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 6

Modigliani-Miller approach 3

Answer 6

Consider two firms that generate the same stream of operating income (or cash flows).

Question 7

These firms differ in their capital structure:

Answer 7

Firm U does not have any debt and, as a result, the value of its equity is equal to the value of the firm (unlettered firm). Eu =Vu
Firm L is levered and the total value of its equity equals the value of the firm less the value of its debt (levered firm). El= Vl -Dl
Questions rises which to invest in?

Question 8

MM Scenario 1:

Answer 8

You decide to buy 1% of firm U. You pay 0.01 x Vu and in return, you claim 1% of the firm’s profits (risk-averse).

Question 9

MM Scenario 1: continued

Answer 9

Alternatively, you may decide to buy 1% of both equity and debt of firm L (diversify). In this case, 0.01xEl +0.01xDl, and you have a claim of, 1% of the firm’s net profits (profits less interest payments on debt)

Question 10

MM Scenario 1: continued 2

Answer 10

Both strategies offer the same return on our investment, equal to 1% of profits. The absence of arbitrage opportunities means that strategies with the same return should have the same cost.

Question 11

The law of one price tells us that:

Answer 11

in the efficient/well-functioning markets, two investments that offer the same payoff must have the same price

The value of the unlettered firm must equal the value of the levered firm.

Question 12

MM Scenario 2:

Answer 12

You decide to buy 1% of firm L. You pay 0.01xEl and in return, you claim 1% of the firm’s net profits (relatively less risk-averse).

Question 13

Alternatively, you may decide to borrow an amount equal to 0.01xDl and purchase 1% of firm U (diversify).

Answer 13

In this case, you have a claim of 1% of the profits of firm U. But you have to pay interest on your debt.

Question 14

MM Scenario 2: 2

Answer 14

Both strategies offer the same return on our investment, equal to 1% of interest payments. In efficient markets the absence of arbitrage opportunities means that strategies with the same return (0.01x(profits-interest)) should have the same cost/price. The value of the unlevered firm is equal to the value of the levered firm.

Question 15

MM proportion I:

Answer 15

The market value of any firm is independent of its capital structure. Firm value and therefore shareholders’ wealth is not determined by its capital structure. Firm value is determined on the left-hand side of the balance sheet, by real assets and not by the proportions of debt and equity securities issued to buy the assets.

Question 16

MM assumptions 1

Answer 16

• 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 arbitrages opportunities.

Question 17

MM assumptions 2

Answer 17

absence of taxation: in reality interest payments are tax deductible (contrary to dividends). Levered firms can reduce overall tax obligations (advantages on leverage) differential taxation on dividends and payments from bonds.

Question 18

MM assumptions 3

Answer 18

absence of bankruptcy costs

investment opportunities unaffected by financing decisions.

Question 19

In absence of arbitrage.

Answer 19

the M-M proposition I applies, shareholders can borrow on their own account at the same terms as the firm.

Question 20

So if the firm goes ahead and borrows.

Answer 20

it will not allow investors to do anything that they could not do already, and so… it will not increase value

Question 21

The share of the company under leverage must cost the same as…

Answer 21

the share of the company with no leverage (given, of course, identical operating incomes)

Question 22

What changes is the return on equity.

Answer 22

not the overall return on assets.

Question 23

Leverage increases the expected stream of … but not

Answer 23

earnings per share… the share price

Question 24

A company’s borrowing decision does not affect either the…

Answer 24

firm’s operating income or the total market value of its securities.

Question 25

Borrowing decision also does not affect.

Answer 25

the expected return on the company’s assets

Question 26

If the investor holds all of a company’s debt and all of its equity..

Answer 26

he is entitled to all the firm’s operating income, the expected return on the portfolio is just rA.

Question 27

So rA will be equal to a weighted average of the expected

Answer 27

returns on the individual holdings.

Question 28

MM Prposition II:

Answer 28

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 and the return on debt.

Question 29

Expected Return

Answer 29

The expected return is the profit or loss that an investor anticipates on an investment that has known historical rates of return (RoR). It is calculated by multiplying potential outcomes by the chances of them occurring and then totaling these results.

Question 30

MM Proposition II: implication 1

Answer 30

• what matters is the operating income (or cash flows) and the overall market value of our financial assets.
• the composition of our financial assets is irrelevant.

Question 31

MM Proposition II: implication 2

Answer 31

Leverage only creates a positive spread between the expected return on equity and the expected return of financial assets.

Question 32

MM prop I summary

Answer 32

Says that financial leverage has no effect on shareholders’ wealth.

Question 33

MM prop II summary

Answer 33

Says that the rate of return they can expect to receive on their shares increases as the firm’s debt-equity ratio increases.

Question 34

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

Answer 34

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

Question 35

Implications of MM propositions for returns 1

Answer 35

• 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, debt holders demand a higher return on debt.
• this causes the rate of increase in rE to slow down.

Question 36

Implications of MM propositions for returns 2

Answer 36

• as the firm borrows more, the risk of default increases and the firm is required to pay higher rates of interest
• popr 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 37

Why does the slope of the rE line decreases as D/E increases?

Answer 37

Because holders of risky debt bear some off firm’s financial risk. As the firm borrows more, more of that risk is transferred from stockholders to bondholders

Question 38

MM ignored taxation

Answer 38

• in many circumstances, interest paid on a firm’s debt can be deducted from taxable income.
• this means that the after-tax cost of debt is rD(1-Tc) where Tc is cororation tax rate.

Question 39

The MM proposition is challenged

Answer 39

ceteris paribus as debt increases the after-tax WACC falls

Question 40

Corporate taxes and value of levered firms

Answer 40

• as seen above, debt creates a tax shield for levered firms
• this is because it reduces taxable income
• if rD is the interest (or return) on debt and D is the amount of debt

Question 41

The proposition that the cost of equity is a positive linear function of capital structure is called the

Answer 41

MM Proposition II.

Question 42

The cost of capital for a firm, rWACC, in a zero tax environment is:

Answer 42

• Equal to the expected earnings divided by market value of the unlevered firm
• Equal to the rate of return for that business risk class
• Equal to the overall rate of return required on the levered firm
• Is constant regardless of the amount of leverage

Question 43

The Modigliani-Miller Proposition I without taxes states that

Answer 43

a firm cannot change the total value of its outstanding securities by changing its capital structure proportions.

Question 44

MM Proposition I without taxes is used to illustrate:

Answer 44

• The value of an unlevered firm equals that of a levered firm
• That one capital structure is as good as another
• Leverage does not affect the value of the firm
• Capital structure changes have no effect on stockholder’s welfare.

Question 45

A key assumption of MM’s proposition I without taxes is that

Answer 45

individuals must be able to borrow on their own account at rates equal to the firm

Question 46

When comparing levered vs. un-levered capital structures, leverage works to increase EPS for high levels of EBIT because:

Answer 46

interest payments on the debt stay fixed, leaving more income to be distributed over less shares.