Los 25.b Flashcards
(15 cards)
What does MM Proposition I (No Taxes) state about capital structure?
MM Proposition I states that under certain assumptions, a firm’s value is unaffected by its capital structure. The value of the firm remains constant, regardless of how debt and equity are mixed.
What assumptions are made in MM Proposition I?
The assumptions include perfect capital markets, no taxes or bankruptcy costs, homogeneous investor expectations, riskless borrowing/lending, no agency costs, and that investment decisions are independent of financing decisions.
How does MM Proposition I relate to the pie analogy?
MM I suggests that the total value of a firm (the pie) does not change based on its capital structure (how the pie is sliced), meaning the value of debt and equity combined remains the same.
What does MM Proposition II state about the cost of equity and leverage?
MM Proposition II states that as a company increases its debt, the cost of equity increases linearly because equity holders face higher risk. The total cost of capital (WACC) remains unchanged, as the lower cost of debt offsets the increased cost of equity.
How is the relationship between the cost of equity and debt-to-equity ratio expressed in MM II?
Calculation: Cost of Equity = Cost of equity with no debt + debt-equity ratio x - (cost of equity - cost of debt)
As leverage (the debt-to-equity ratio) increases, the cost of equity increases, but the cost of debt and WACC are unchanged. This relationship between the cost of equity financing and the debt-to-equity ratio is illustrated in MM Proposition II (No Taxes).
What does MM Proposition II conclude about WACC and debt?
MM Proposition II concludes that as leverage increases, the cost of equity rises, but the overall WACC remains the same, meaning the firm’s value is unaffected by its capital structure when there are no taxes.
What happens in MM with taxes?
With taxes, debt financing becomes more attractive because interest payments are tax-deductible, creating a tax shield. This increases the value of the firm, and the optimal capital structure is 100% debt.
What is the formula for return on equity in MM with taxes?
Calculation: Cost of Equity = Cost of equity with no debt + debt-equity ratio x - (cost of equity - cost of debt) (1-tax rate)
Why don’t companies typically use 100% debt financing in practice?
Although 100% debt maximizes firm value in theory, in practice, companies face bankruptcy costs and financial distress, which increase as debt levels rise.
What are the costs of financial distress?
Costs of financial distress and bankruptcy can be direct or indirect. Direct costs of financial distress include the cash expenses associated with the bankruptcy, such as legal fees and administrative fees. Indirect costs include foregone investment opportunities and the costs that result from losing the trust of customers, creditors, suppliers, and employees. Additionally, during periods of financial distress, conflicts of interest between managers (who represent equity owners) and debtholders impose additional costs, referred to as the agency costs of debt.
The probability of financial distress is related to the firm’s use of operating and financial leverage. In general, higher amounts of financial leverage increase the probability of financial distress (higher probability that cash flows will fall to an amount that is insufficient to make their promised debt payments). Other factors to consider include the quality of a firm’s management and the company’s corporate governance structure. Lower-quality management and poor corporate governance lead to a higher probability of financial distress.
How does financial leverage impact the probability of financial distress?
As financial leverage increases, the probability of financial distress rises because there’s a higher chance that cash flows won’t be sufficient to meet debt obligations.
What factors influence the costs of financial distress?
actors include the firm’s level of operating and financial leverage, the quality of management, and the corporate governance structure. Poor management and governance increase the likelihood of distress.
As debt levels rise, the expected costs of financial distress increase, which reduces the total value of the firm, making high debt less desirable.
