Capital Structure I Flashcards
(19 cards)
What does capital structure refer to?
It’s the mix of debt and equity a company uses to finance its operations and assets.
What does Modigliani-Miller Proposition I state?
In perfect markets, capital structure does not affect firm value.
What is M&M Proposition II?
The cost of equity increases with leverage, but WACC remains constant.
What is the value of a levered firm according to M&M with taxes?
VL = VU+τ cD where
τ c is the corporate tax rate and D is the debt.
What is capital structure?
Capital structure is the mix of debt and equity a firm uses to finance its operations and investments.
What is leverage in finance?
Leverage refers to the use of borrowed funds (debt) to finance part of a firm’s operations. It increases both potential returns and risk to equity holders.
How does leverage affect EPS (Earnings Per Share)?
Leverage amplifies EPS when firm earnings are high, but reduces EPS more sharply when earnings are low. It increases the volatility of equity returns.
What did Modigliani and Miller (M&M) propose in Proposition I (no taxes)?
n a perfect capital market, a firm’s value is independent of its capital structure. So VL = VU
VL - Value of the leveraged firm
VU - Value of the unleveraged firm
What is the intuition behind M&M Proposition I?
Changing the mix of debt and equity does not affect the total cash flow available to investors. It only repackages risk, not value.
What is homemade leverage?
Investors can replicate the effects of corporate leverage by borrowing or lending on their own, maintaining the same total return, supporting M&M’s irrelevance theory.
What is the effect of leverage on equity risk (Proposition II)?
M&M Proposition II states that as leverage increases, the cost of equity rises because equity becomes riskier. However, the firm’s WACC stays the same.
What is the formula for M&M Proposition II (no taxes)?
re = r0 + (r0 - rd) * (D/E)
re - cost of equity
r0 - cost of capital for unlevered firm
rd - cost of debt
D/E - debt to equity ratio
What is the role of taxes in capital structure decisions?
In reality, interest is tax-deductible, which creates a tax shield. This makes debt financing more attractive, increasing the value of levered firms.
What is the value of a levered firm with taxes?
VL = VU + PV of tax shield
If debt is permanent:
VL = VU +Tc*D
Where Tc = Corp tax rate and D = amount of debt
What is the present value of the interest tax shield?
PV(Tax shield) = Tc*D
Assuming perpetual debt and constant tax rate
How does the tax shield affect WACC?
The WACC decreases as more debt is used because the after-tax cost of debt is lower due to the interest tax shield.
Why can’t a firm use 100% debt if it’s cheaper?
High levels of debt increase the risk of financial distress, lead to higher interest rates, and increase agency costs, which offset the tax benefits of debt.
What is the conservation of value principle?
In perfect markets, financial transactions do not create value—they only reallocate it. This supports the M&M idea that capital structure is irrelevant under certain conditions.
What are the assumptions of the Modigliani-Miller model?
No taxes
No transaction or bankruptcy costs
Symmetric information
Individuals and firms can borrow/lend at the same rate
No effect of capital structure on investment decisions
