Debt policy

Question 1

Why does MM believe a financial manager shouldn’t worry about the perfect combination of securities that maximises value of the firm?

Answer 1

• in a perfect market any combination is as good as another

Question 2

What is capital structure?

Answer 2

• a mix of debt and equity financing

Question 3

Define financial leverage

Answer 3

finance of investment partly or wholly by debt

Question 4

What is Modigliani-Miller’s Proposition I?

Answer 4

The value of the firm is unaffected by its choice of capital structure

Question 5

What is an unlevered firm?

Answer 5

one with no debt

Question 6

In MM prop. 1 does the value of an unlevered firm = the value of a levered firm?

Answer 6

Yes as market value of any firm is independent to its capital structure

Question 7

What assumptions does the MM prop 1 rely on? (5)

Answer 7

• competitive markets: individuals can borrow and lend at the same rate as firms
• markets are efficient (symmetric information etc)
• absence of taxation (in reality interest is tax deductible unlike dividends)
• absence of bankruptcy costs
• investment opportunities unaffected by financing decisions

Question 8

True or false, leverage increases the share price but not EPS

Answer 8

false

Question 9

What equation can be used to calculate the expected return on a company’s assets?

Answer 9

rA = expected operating income / market value of all securities

Question 10

Why does a company’s borrowing decision not affect a firms’s expected return (rE)?

Answer 10

• the borrowing decision doesn’t effect the firm’s operating income or the total market value of its assets which make up the equation that equals rA

Question 11

What is the weighted average cost of capital (WACC) equation?

Answer 11

rA = (E/ E+D)rE + (D/ E+D)rD

Question 12

How do you solve for rE?

Answer 12

rE = rA + (rA - rD) D/E

Question 13

What is MM’s proposition II?

Answer 13

• rate of return on shares increases as the firm’s debt-equity ratio increases

Question 14

What are the implication of the MM propositions?

Answer 14

1- what matters is the operating income and the overall marekt value of financial assets
2- leverage only creates a positive spread between the exp return on equity and exp return of rA of financial assets (if D>0 then rE>rA)

Question 15

When a firm is levered will equity investors recieve a higher return?

Answer 15

Yes, as a premium will be required to compensate for the extra risk

Question 16

What happens to rE as leverage increases? (w out tax- MM2)

Answer 16

It increases. Shareholders demand a higher return on their equity for the added risk.

Question 17

MM ignores taxation, how does this change the WACC equation?

Answer 17

add (1-TC) to the end

Question 18

How can debt be useful to firms?

Answer 18

it can act as a tax shield as interest payments are tax deductible

Question 19

How do you calculate eps?

Answer 19

operating income / no. of shares

Question 20

How do you calculate return on equity ? using EPS

Answer 20

EPS / Price

Question 21

how can you calculate OI using rE?

Answer 21

OI = rE * market value