Lecture 5

Question 1

What characterizes perfect capital markets?

Answer 1

– No taxes, transaction costs, security issuance costs, borrowing constraints, etc.

– Investors and firms can trade all securities at prices equal to the present values of their cash flows

Question 2

Which are the two propositions of the Modigliani-Miller theorem?

Answer 2

1. In perfect capital markets, the total value of a firm is equal to the market value of the total cash-flow generated by its assets, and it is not affected by the choice of capital structure. V(U) = V(L)
2. The cost of capital of levered equity increases with the firm’s debt/equity ratio

Question 3

What is another name for Modigliani-Millers proposition 1?

Answer 3

Capital Structure Irrelevance Proposition

Question 4

Why is (1-t) part of the WACC formula?

Answer 4

To account for the tax shield

Question 5

Considering the interest tax shield, why are all firms not financed by debt?

Answer 5

• Costs of Financial Distress
• Agency Costs of Debt
• An investor pays personal taxes on interest and dividend income; taxes on dividend income may be lower than taxes on interest income; hence, the tax advantage of debt at the corporate level must be balanced at the tax advantage of equity at the personal level of the firm’s owners

Question 6

Define financial distress

Answer 6

When company cash-flows are insufficient to meet debt payments

Question 7

Name two types of costs of financial distress

Answer 7

• Cost of bankruptcy

* Agency cost of debt

Question 8

Describe the two types of agency cost of debt

Answer 8

• Debt overhang - overinvestment:
Managers may take on some negative NPV projects if these projects increase the value of equity, even if they decrease total firm value

• Debt overhang - underinvestment:
Managers (shareholders) may not take on some positive NPV projects if most of the benefits go to debtholders