B3 Capital Structure

Question 1

Assumptions MM-Theorem (Modigliani-Miller)

Answer 1

(1) There are no taxes
(2) Managers have stockholder interests at hear and do what’s best for stockholders
(3) No bankruptcies
(4) Equity investors are honest with lenders; there is no subterfuge or attempt to find loopholes in loan agreements
(5) Firms know their future financing needs with certainty

Question 2

MM-Proposition I

Answer 2

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

Question 3

MM-Proposition II

Answer 3

The cost of capital of levered equity is equal to the cost of capital of unlettered equity plus a premium that is proportional to the market value debt-equity ratio
r_E=r_U+D/E(r_U-r_D)

Question 4

What is Homemade Leverage?

Answer 4

(1) Investors use leverage in their own portfolio to adjust the leverage choice made by the firm.
(2) Perfect substitute for the use of leverage by the firm as long as investors have the same borrowing and lending interest rates as the firm

Question 5

Trade-off theory of capital structure: +/- debt and implication

Answer 5

Question 6

Advantages of debt: Tax benefits of debt (tax shield)

Answer 6

(1) Interest rate expenses are tax deductable
(2) tax benefit p.a. = tax rate x interest payment
(3) Value of the firm increases with additional debt:
V_{firm with debt} = V_{all equity} + *PV *(tax shield)
with tax shield = marginal tax rate t * debt D

Question 7

Advantages of debt: Added discipline to management

Answer 7

(1) Managers of all-equity firms that have generated high income and CFs in the past tend to become complacent, leading to inefficiency and investments in poor projects.
(2) Additional debt can add discipline to the management as they have to ensure to invest only in projects generating CFs that at least cover interest payments -> Otherwise bankruptcy and therefore job loss

Question 8

Bankruptcy cost: two variables influencing bankruptcy cost

Answer 8

Expected bankruptcy cost depends on two variables:
1. cost of going bankrupt:
(a) direct costs: legal and other deadweight costs
(b) indirect costs: arising because people perceive you are in financial trouble
2. probability of bankruptcy, which depends upon the (un)certainty of future CFs
=> more debt increases probability of bankruptcy and hence expected bankruptcy cost.
The higher the probability of bankruptcy and indirect cost the less debt can a firm afford to use.

Question 9

Probability of bankruptcy

Answer 9

Depends upon future CF volatility:
(1) Riskiness of industry and firm’s strategy
(2) Uncertainties induced by competition
(3) Risk of technological change
(4) Sensitivity to macroeconomic shocks and seasonal fluctuations
=> Use past data, knowledge on industry and beware of environmental changes!

Question 10

3 indirect costs of financial distress

Answer 10

(1) Debt overhang: inability to raise funds to undertake investments
(2) Scare off customers and suppliers
(3) Asset fire sales: assets may be less valuable or cash constrained when trying to sell them

Question 11

Disadvantages of borrowing: Agency cost

Answer 11

Agency costs arise when interests of principal (lender) and agent (borrower) deviate:

1. Agent invests in riskier projects than principal wants
2. Agent pays large dividend instead of keeping cash in the business

=> the greater the agency problems associated with lending to a firm, the less debt the firm can afford to use

Question 12

Loss of future financing flexibility

Answer 12

When firm borrows up to its capacity, it loses flexibility of financing future projects with debt

=> the more uncertain a firm is about its future financing requirements and projects, the less debt it will use for financing current projects

Question 13

Trade-off theory: formula firm value

Answer 13

V^L = V^U + *PV *(interest tax shield) — *PV *(financial distress costs)

Question 14

Trade-off theory: graphic

Answer 14

Question 15

Pecking order theory

Answer 15

Managers prefer to finance investments wrt. the following order:

(1) Internal financing (retained earnings)
(2) External financing via debt (straight/convertible debt)
(3) External financing via equity (common equity, straight preferred stock, convertible preferred stock)

Why? information asymmetries between firm and market (external more costly than internal; equity more costly than debt)

Question 16

Summary on Capital Structure (MM, Trade-off, pecking order)

Answer 16

MM: Total value of a firm is not affected by its choice of capital structure

Trade-off theory: Firms optimize costs and benefits of debt relative to equity

Pecking-order theory: Firms preferably use retained earnings, then borrow from debt market and as a last resort, issue equity