Capital Structure

Question 1

Finance by Equity

Answer 1

If financed entirely by equity, these cash flows all belong to the shareholders

Question 2

Finance by Debt

Answer 2

If partially financed by debt, the cash flows which go to the bondholders are a relatively safe stream

Question 3

If financed by equity and debt

Answer 3

the cash flows are split up into a relatively safe stream, that goes to the bondholders, and a more risky, residual stream that pertains to the shareholders

Question 4

capital structure

Answer 4

The mix of different securities and is chosen to have the greatest overall appeal to investors and thereby maximizing overall market value

Question 5

Modigliani & Miller

Answer 5

Assumptions about perfect markets and symmetric information,
no taxes as well as no costs of financial distress.

Question 6

Trade-off theory
(part 1)

Answer 6

Taxes are introduced in the Modigliani & Miller world

Question 7

Trade-off theory
(part 2)

Answer 7

Costs of financial distress are taken into account in the Modigliani & Miller world with taxes

Question 8

Pecking order
theory

Answer 8

Asymmetric information (and signaling) influences the choice between internal, debt, and equity financing

Question 9

Assumptions of the Modigliani & Miller World

Answer 9

• Perfect markets: No transaction costs, perfect information, etc
  –> Law of one price: Assets with the same payoff have the same
  price
  –> Investors can borrow and lend at the same rates as the firm, and can thereby do (or «undo») a firm’s financing decisions
• No taxes
• Payout policy (dividend, repurchase) is ignored
• Capital structure choice does not affect investement and operating policies

Question 10

Unlevered Firm (U)

Answer 10

A firm that is entirely equity-financed, meaning it has no debt

Question 11

Levered Firm (L)

Answer 11

A firm that uses a mix of debt and equity to finance its operations

Question 12

MM Proposition I:

Answer 12

• investors can “undo” a firm’s financing policy : individual investors can adjust their own personal leverage to achieve the same outcomes
• If the value of two assets is the same when combining them (value additivity), this also holds when splitting them
• The value is determined by the PVs of cash flows generated by a firm’s assets, not by the securities issued to buy the assets
• Absent taxes and bankruptcy risk, the weighted average cost of capital does not depend on the ratio between debt and equity

–> With perfect capital markets and no taxes
the value of the firm is independent of its capital structure

Question 13

expected return on assets (calculation)

Answer 13

expected operating income/market value of all securities

Question 14

unlevered firm X

Answer 14

return asset = return equity

Question 15

levered firm X

Answer 15

return on equity = return on asset + D/ E (rA-rD)

Question 16

Expected EPS (earning per share)

Answer 16

Operating income / shares

Question 17

Expected ROE (return on equity)

Answer 17

EPS/share price

Question 18

Are equity investors better off when the firm is levered?

Answer 18

No, because increases in expected return are exactly offset by an increase in risk and required rate of return (see subsequent
slides)

Question 19

Modigliani and Miller Example for no taxes (graph)

Answer 19

Equal Proportion of Debt and Equity / All equity

–> The two lines cross at the point where the
return on the market value of assets is equal
to the interest rate paid on debt

Question 20

MM Proposition II:

Answer 20

The expected return on equity of a levered
firm increases with the D/E ratio. The rate of increase depends on the spread between the expected return on assets and the return on debt.
–> The effect of leverage depends on the company’s earnings

Question 21

findings seem contradictory, why?

Answer 21

While MM Proposition I states that the value of the company is independent of its capital structure, Proposition II states that increasing leverage increases the expected
return on equity

–> expected return on equity increases with leverage does not mean that shareholders are better off
–> expected (or “required”) return on equity must increase to compensate shareholders
for the increase in risk brought about by the increase in leverage

Question 22

return on equity

Answer 22

return on assets + risk premium

= ra + (ra - rd) D/E

Question 23

Any increase in expected return is exactly offset by..

Answer 23

an increase in risk and the required rate of return

Question 24

Why does equity become riskier as leverage increases? Debt and equity risk (no taxes)

Answer 24

• The change in financial structure does not affect the amount or risk of the cash flows on the total package of debt and equity
• Increasing the amount of debt also increases debt holder risk –> debt holders are likely to ask for a higher return
• As the firm borrows more, more of the business risk is transferred from stockholders to bondholders
• More borrowing also increases equity risk and the required return on equity increases as well
• The weighted average return on debt and equity is, however unaffected

Question 25

Modigliani and Miller : Limitations

Answer 25

Market imperfections: 1. Firms incur costs for issuing securities 2. Firms and investors do not face identical borrowing and lending costs 3. Pooling single investors’ interests reduces transaction costs 4. Corporate bond schemes allow to circumvent regulatory constraints 5. The set of securities available to investors is incomplete 6. Credit risk can lead to conflicts of interest between debt investors, equity investors, and management

Question 26

The trade-off theory I with taxes

Answer 26

- relaxes the assumptions of no taxes and no costs of financial distress - a third claimant to a firm's cash flows in addition to debt and equity holders: The government taxes cash flows to equity and debt differently --> interest paid on a firm’s borrowing is seen as a business expense and is deductible from taxable income --> Dividends are treated as a return to the firm’s owners and are therefore not tax deductible = difference creates a bias towards debt. Holding before-tax cash flows fixed, debt finance reduces a firm’s taxable income, resulting in higher after-tax cash flows

Question 27

present value of this tax shield : calculation

Answer 27

PV (tax shield) = corporate tax rate x interest payment / expected return on debt

Question 28

Interest payment

Answer 28

Interest payment = return on debt x amount borrowed

Question 29

After tax WACC : calculation

Answer 29

E / E + D x re + D / E + D x rd (1- Tc)

Question 30

Value of levered firm (VL)

Answer 30

Value of unlevered firm (VU) + PV tax shield (TCD)

Question 31

Costs of financial distress

Answer 31

- trade-off theory proposes bankruptcy costs, and more generally, costs of financial distress as the main costs of debt finance. - In the MM world, when the value of equity falls to zero, debt holders take over the firm. There should be no costs to bankruptcy because there is no reduction in the cash flows generated by the company. - there may be sizeable costs of bankruptcy. These costs make debt less attractive because they reduce the expected value of the firm’s cash flows

Question 32

Direct cost of bankruptcy

Answer 32

Lawyers and bankruptcy judges are examples of direct costs of financial distress. --> Academic research suggests that these costs are relatively small and too small to account for the low observed debt ratios

Question 33

Indirect costs of bankruptcy

Answer 33

Managerial attention diverted from managing assets to managing liabilities.

Question 34

Direct and indirect costs of bankruptcy

Answer 34

- Firm loses flexibility when monitored closely by creditors - Assets must be sold in fire-sales. Firms with highly specific assets obtain the worst prices. Especially true if assets do not have value outside the industry and the industry is cyclical - Intangible assets may be destroyed if the firm is broken up or sold. Firms with high advertising or R&D expenditure have lower than average debt ratios (tech firms). Firms with high expenditure on property, plant & equipment have higher than average debt ratios (hotels).

Question 35

pecking order theory: definition

Answer 35

managers know more about their companies’ prospects, risks, and value than outsiders results in asymmetric information

Question 36

Asymmetric information affects what?

Answer 36

the choice between internal and external financing and between new issues of debt and equity securities --> Asymmetric information problems lead to a pecking order, in which an investment is financed

Question 37

Asymmetric information: 3 choice

Answer 37

1. first choice : Internal financing 2. second choice : Debt 3. third choice : Equity

Question 38

New equity issues, when ?

Answer 38

last resort when the company runs out of debt capacity, because of costs of financial distress

Question 39

If both firms need to raise capital, they can choose between ...

Answer 39

issuing new debt and issuing new common stock

Question 40

Issue of debt

Answer 40

shares currently trade below the actual value (underpriced).

Question 41

Issue of shares

Answer 41

shares currently trade above the actual value (overpriced)

Question 42

The decision to issue stock alone implies that..

Answer 42

it must be overvalued so that the market will discount the share price upon announcement --> both managers will favor debt issues over equity issues

Question 43

If external finance is required, what do firms?

Answer 43

If external finance is required, firms issue the safest security first. That is, they start with debt, then possibly hybrid securities, and finally equity as a last resort

Question 44

The pecking order theory explains

Answer 44

the inverse (intra-industry) relationship between profitability and financial leverage

Question 45

The most profitable firms borrow less, why ?

Answer 45

because they are less dependent on outside financing. The attraction of interest tax shields is of secondary importance.

Question 46

Debt ratios change when?

Answer 46

There is an imbalance of internal cash flow, net of dividends, and real investment opportunities

Question 47

The observed debt ratios reflect what?

Answer 47

each firm’s cumulative requirement for external financing

Question 48

Debt ratios depend on four main factor ( Rajan and Zingales, 1995)

Answer 48

1. Size 2. Tangible assets 3. Profitability 4. Market to book

Question 49

Size

Answer 49

Observation: Larger firms tend to have higher debt ratios Trade-off theory : Large firms have a lower risk of financial distress

Question 50

Tangible assets

Answer 50

Observation: Firms with high ratios of fixed assets to total assets have higher debt ratios Trade off theory : Firms with more tangible assets have a lower costs of financial distress

Question 51

Profitability

Answer 51

Observation : More profitable firms have lower debt ratios Pecking order theory : Profitable firms rely on internal finance

Question 52

Market to book

Answer 52

Observation : Firms with higher ratios of market-to-book value have lower debt ratios Trade off theory : Growth opportunities increase risk of financial distress Pecking order theory : Higher Market Book ratio implies profitability, thus higher reliance on internal finance

Question 53

Heider and Ljungqvist (2015)

Answer 53

- The problem of most research: Debt / leverage is endogenously determined. Results represent correlations, no causality - Heider and Ljungqvist (2015) propose a novel empirical approach that exploits state-wise changes in corporate income tax rates - They use state-level changes in corporate income taxes (affecting different companies at different points in time) to investigate the effect of taxes on leverage - To control for industry- and state-specific developments, compare leverage changes among North Carolina firms in 1991 (tax raise) to contemporaneous changes in leverage among firms that operate in the same industry but are located in states without tax changes in 1991, say in South Carolina - They show that taxes have a first-order effect on capital structure: On average, firms increase leverage by around 40 basis points for every percentage-point tax increase.