3.1: Capital Structure in Perfect Capital Markets

Question 1

What do we often use to estimate a project’s beta?

Answer 1

Identify comparable firms. If we can estimate the cost of capital of the assets of these, we can use that as a proxy for the project’s beta and cost of capital

Question 2

What is the beta of a portfolio?

Answer 2

The weighted average of the betas of the securities within it

Question 3

What can happen when the firm has excess cash (more cash than debt)?

Answer 3

Net debt will be negative, and unlevered beta and cost of capital will exceed the equity beta and cost of capital, since the risk of the equity is mitigated by the cash holdings

Question 4

Why may we use net debt to assess a firm?

Answer 4

If the firm has large cash holdings, it represents a risk-free asset on the balance sheet. We often are interested in the risk of the firm’s underlying business operations, separate from its cash holdings. Then we can measure the leverage in terms of net debt

Question 5

What is the formula for net debt?

Answer 5

Net debt = Debt - Excess cash and short-term investments

Question 6

What types of businesses tend to have high/low asset betas?

Answer 6

High: Cyclical industries such as steel and high technology

Low: Utilities and household products

Question 7

What constitute a firm’s capital structure?

Answer 7

The relative proportions of debt, equity and other securities that the firm has outstanding

Question 8

What is unlevered equity?

Answer 8

Equity in a firm with no debt

Question 9

What is levered equity?

Answer 9

Equity in a firm that also has debt outstanding

Question 10

Who has priority for cash flows from the firm?

Answer 10

Debt holders. But equity holders have limited liability and can not get less than 0

Question 11

Why can we not discount cash flows of levered equity with the same discount rate as for unlevered equity?

Answer 11

Because leverage increases the risk of the equity of a firm (even when there is no risk that the firm defaults), so we must use a higher rate since investors require a higher expected return to compensate for the increased risk

Question 12

What are the conditions for perfect capital markets under MM?

Answer 12

1. Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.
2. There are no taxes, transaction costs, or issuance costs associated with security trading.
3. A firm’s financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them.

Question 13

What is the MM Proposition I?

Answer 13

In a perfect capital market, the total value of a firm’s securities is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.

• The total cash flows paid out to all security holders is equal to the total cash flows generated by the assets. Therefore, by the law of one price, the firm’s securities and assets must have the same total market value

Question 14

What is homemade leverage?

Answer 14

MM showed that investors who prefer an alternative capital structure to the one the firm has chosen can borrow or lend to achieve the desired result. When investors use leverage in their own portfolios to adjust the leverage choice of the firm, they are using homemade leverage. It is a perfect substitute as long as they can borrow/lend at the same rate as the firm

Question 15

What are two differences of the market value balance sheet compared to the accounting balance sheet?

Answer 15

1. All assets and liabilities of the firm are included, even intangibles such as reputation, brand name, or human capital.
2. All values are current market values rather than historical costs.

Question 16

What is a leveraged recapitalisation?

Answer 16

When a firm borrows and increase leverage, and use the funds to repurchase a significant percentage of its outstanding shares.

Question 17

What three balance sheets can we draw up when considering a leveraged recapitalisation?

Answer 17

• Initial
• After borrowing
• After share repurchase

Question 18

What is the MM Proposition II?

Answer 18

The cost of capital of levered equity increases with the firm’s market value debt-equity ratio

Question 19

How can cash holdings be viewed in relation to leverage?

Answer 19

As the opposite effect of leverage on risk and return, so as negative debt

Question 20

What are two incorrect arguments that are sometimes cited in favour of leverage?

Answer 20

• Leverage can increase expected EPS, so then it should also increase stock price. But, as EPS rises with leverage on average, so does the risk of the EPS. Hence, we use a higher discount rate, and the share price does not increase
• Issuing equity will dilute existing shareholders’ ownership, so debt should be used instead. This is wrong since the cash raised issuing new shares will increase the firm’s assets. As long as new shares are sold at a fair price, there will be no gain or loss from the issue itself