T5 Debt Policy

Question 1

Capital structure
Financial leverage

Answer 1

firms mix of debt and equity financing
finance of investment partly of wholly by debt

Question 2

The financial manager wants to find the combination of securities that maximises value of the firm. How is this done according to MM.

Answer 2

FM should stop worrying. The value of the firm is unaffected by its choice of capital structure

Question 3

The law of one price

Answer 3

in efficient markets, 2 investments that offer the same payoff must have the same price

Question 4

Law of one price continued

Question 5

MM proposition 1

Answer 5

The market value of any firm is independent of its capital structure

Question 6

MM proposition Assumptions

Answer 6

Competitive Markets - people can borrow and lend at same rate
Efficient Markets - complete and symmetric information
Absence of taxation
Absence of bankruptcy costs

Question 7

Question 8

Question 9

Why does borrowing not increase value of the firm

Answer 9

Company under leverage costs the same as company with no leverage. What changes Is return on equity not overall return on assets.

Question 10

Leverage increases the expected stream of earnings per share but not share price

Question 11

Expected return on company’s assets

Answer 11

rA = expected operating income/market value of all securities. Borrowing does not affect this.

Question 12

Expected return on a portfolio

Answer 12

Known as weighted average cost of capital (WACC)

Question 13

Solving the WACC for re we get… which leads to proposition 2

Answer 13

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

Question 14

MMs Implication

Question 15

Question 16

MMs Proposition 1 & 2

Answer 16

1: financial leverage has no effect on shareholders wealth
2: rate of return they can expect to receive on shares increases as firms debt equity ratio increases

Question 17

WAAC question

Answer 17

Question 18

Answer 18

Question 19

Answer 19

Question 20

Answer 20

Question 21

Answer 21

Question 22

Question 23

Question 24

WACC after tax formula

Answer 24

Question 25

Answer 25

Question 26

Without taxes WACC would be

Answer 26

Question 27

Question 28

Question 29

Answer 29

Question 30

Question 31

WACC with no debt

Answer 31

Just rate of return on equity