L6 - Capital Structure

Question 1

What is the fundamental idea behind the Capital Structure Question and the Pie Theory?

Answer 1

The value of a firm is the sum of its debt (B) and equity (S): V = B + S

Question 2

According to the Pie Theory, what should a firm do to maximise its value?

Answer 2

The firm should choose the debt/ equity ratio that makes the firm value as big as possible

Question 3

What are the two important questions related to capital structure?

Answer 3

• Why should stockholders care about maximizing firm value?
• What debt-equity ratio maximizes shareholder value?

Question 4

When do changes in capital structure benefit the stockholders?

Answer 4

If and only if the value of the firm increases

Question 5

What are the assumptions of the M&M model?

Answer 5

• Homogeneous expectations
• Homogeneous risk classes
• Perpetual cash flows
• Perfect capital markets

Question 6

What are the characteristics of Perfect Capital Markets?

Answer 6

• Perfect competition
• Equal borrowing/ lending rates
• Equal access to all relevant info
• No transaction costs
• No taxes

Question 7

Explain the concept of ‘Homemade Leverage’ in the context of M&M

Answer 7

Investors can create their own leverage to achieve desired returns, making firm leverage irrelevant in a perfect market

Question 8

State M&M Proposition 1 (no taxes)

Answer 8

Firm Value is not affected by leverage

Question 9

State M&M Proposition 2 (no taxes)

Answer 9

Leverage increases risk and return to stockholders

Question 10

In M&M Proposition 2 (no taxes), what do rs, r0, and rb represent?

Answer 10

rs = Return on levered equity
ro = return on unlevered equity
rb = interest rate

Question 11

State M&M Proposition 1 (with taxes)

Answer 11

Firm value increases with leverage

Question 12

State M&M Proposition 2 (with taxes)

Answer 12

Some of the increase in equity risk and return is offset by the interest tax shield

Question 13

What is the effect of taxes on the value of a levered firm according to M&M?

Answer 13

The value of a levered firm is equal to the value of an unlevered firm plus the tax shield from debt

Question 14

According to M&M with taxes, why might a firm not choose to have 100% debt in its capital structure?

Answer 14

Because of the potential for bankruptcy costs, which are not considered in the basic M&M model with taxes