Capital Structure

Question 1

What is a firms capital structure and what is its goal?

Answer 1

The capital structure is a firm’s mix of debt providing a relative safe stream of cash flow to debtholders, equity (common and preferred stock) which has a riskier cash flow stream to stockholders, and hybrids (convertible bonds). The goal is to find the perfect combination of securities that maximizes the overall market value of the firm.

Question 2

Modigliani & Miller World: Assumptions, Proposition 1 & 2, and its Implications?

Answer 2

Assumptions: perfect markets (no transaction costs), no taxes, no costs of financial distress

Proposition 1: no combination of securities (levered vs unlevered) is better than any other which means that the firm’s overall market value is independent of its capital structure and rather determined by the present values of cash flows generated by a firm’s assets.

Proposition 2: the effect of leverage (debt/equity) depends on the company’s earnings meaning that the expected ROE of a levered firm increases with the D/E ratio

Why not contradictory? Expected ROE must increase to compensate shareholders for the increase in risk brough by the increase in leverage which means that any increase in exptected return is exactly offset by an increase in risk and the required rate of return.

Question 3

List examples of market imperfections that show that debt policy does indeed matter?

Answer 3

• Firms incur costs of issuing securities
• Firms and investors do not face identical borrowing and lending costs
• The set of securities available to investors is incomplete
• Credit risk can lead to conflicts of interest

Question 4

How do Taxes implicate the Proposition 1 of M&M?

Answer 4

Taxes provide borrowing with an advantage, since interest paid on firm’s borrowing is seen as business expense and is therefore deductible from taxable income while dividends are treated as a return on the firm’s owners and are therefore not tax deductable.
As a result, debt finance reduces a firm’s taxable income resulting in higher after-tax cash flows.

V(L) = V(U) + PV tax shield
–> watch out which formula to use depending on if Debt is fixed or not!

Question 5

How do Costs of Financial Distress implicate the M&M World?

Answer 5

Implications: High level of debt less attractive
While a unlevered firm can easily absorb a “bad holiday season”, a heavily indebted firm may become unable to service its debt obligations and end up bankrupt. There are sizeable costs associated with bankruptcy which makes debt less attractive because they reduce the expected value of the firm’s cash flows.

–> V(L) = V(U) - PV expected costs of financial distress

Direct Cost relatively small (e.g. lawyers, bankruptcy judges)

Indirect Cost:
- Managerial attention diverted from managing assets to managing liabilities
- Firms lose flexibility when monitored closely by creditors
- Assets must be sold in fire-sales which leads to undervalued sales especially for individualized assets
- Intangible assets may be destroyed

Question 6

What is the Optimal Capital Structure?

Answer 6

The optimal capital strucuter is the point where the marginal benefits of an increase in leverage (tax shield) are equal to the marginal costs of financial distress for an increase of a unit of debt.

Question 7

What is the Pecking Order Theory?

Answer 7

Explains the inverse relationship between profitability and financial leverage. Profitable firms rely on internal finance, because they are less dependent on outside financing, and have therefore a lower debt ratio. When external financing is required, companies choose debt over equity because of the interest tax shield benefits explained by the Trade-off theory (but not reach limit when costs of financial distress outweigh gains from tax shields).

The Pecking Order Theory accounts for the signaling effects resulting from asymmetric information. Since managers know more about their companies’ risks and values than outsiders, the issuing of new stock (equity) is interpreted by investors as bad news, since managers are normally reluctant to issue new stock when they believe that the shares are under-priced. As a consequence, stock prices usually fall afterwards. Therefore, new equity issues are a last resort only when debt capacity is running out and financial distress threatens.