S12 - Capital structure

Question 1

What are the different sources of firm financing? Give some examples.

Answer 1

1. Debt (ex.: bank loans, bonds, debentures)
2. Equity capital (ex.: ordinary shares)
3. Hybrids, a mix of debt and equity (ex.: preferences shares, convertible bonds)

Question 2

What are the difference between ordinary shares and debt concerning the following aspects: ownership, right to vote, remuneration, bankruptcy/liquidation, guarantees, lifespan, and tax?

Answer 2

1. Ownership and right to vote
   - ordinary shares -> yes
   - debts -> no
2. Remuneration
   - ordinary shares -> variable dividends
   - debts -> predetermined interests
3. Bankruptcy / liquidation
   - ordinary shares -> last to be paid
   - debts -> before equity holders
4. Guarantees
   - ordinary shares -> no
   - debts -> yes
5. Lifespan
   - ordinary shares -> unlimited
   - debts -> limited
6. Tax
   - ordinary shares -> Dividends not tax deductible, personal tax credit
   - debts -> Interest is tax deductible, personal taxation at 100%

Question 3

Do shareholders like debt?

Answer 3

Increase in debt leads to an increase in E(R).

Debt increase the potential return for share-holders but it increases risk.

Shareholders do like debt, but until a certain point.

Question 4

What are the fundamental objectives of the optimal capital structure?

Answer 4

The optimal CS is the one that:
- maximizes the wealth of common shareholders
- maximizes the company’s value
- minimizes the WACC

Question 5

What are the characteristics of the M&M model without taxes? What happens when debt increase?

Answer 5

Assumptions of a perfect frictionless world:
- no taxes
- no chance of financial distress
- no transaction costs (no brokerage fees/issue costs. liquid market, efficient market, no agency costs)

1. The value of the firm is independent from its capital structure.
2. A firm’s cost of equity capital is a positive linear function of its capital structure.

When debt increases, what are the effects?
1. rd < re: WACC decrease when debt increase (debt is cheaper than equity)

2. Risk increase when debt increase: WACC increase because Re increase (debt increase risk for shareholders)

These tax effects exactly cancel each other out so no optimal CS.

Question 6

What are the characteristics of the M&M model with corporate taxes? What happens when debt increase?

Answer 6

Assumptions:
- corporate taxes
- no personal taxes
- no chance of financial distress
- no transaction costs

Tax assumptions:
- Interest is tax deductible
- Dividends are not tax deductible

1. The value of the firm increases as total debt increases because of the tax shield.
2. A firm’s cost of equity capital is a positive linear function of its capital structure

When debt increases, three effects take place:
1. Rd < Re -> WACC decrease when debt increase
2. Risk increase when debt increase -> Re increase when debt increase -> WACC increase
3. Interest is tax deductible -> Rd decrease then WACC decrease

Illogical Conclusion: If there is no financial distress, the optimal capital structure is 100% debt

Question 7

What are the characteristics of the Static Theory with corporate taxes? What happens when debt increase?

Answer 7

Assumptions
Corporate tax
No Personal tax
Presence of bankruptcy cost
No transaction costs

Static Theory
The firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress.

Financial distress:
Inability to meet financial obligations
Insolvency
Two (2) possible solutions:
Restructuring (operational and/or financial)
Bankruptcy

Effects when debt increase:
Effect 1: kd < ke -> WACC decrease
Effect 2: ↑ leverage = ↑ σEPS = ↑ ke -> WACC increase
Effect 3: kd (1-t) -> WACC decrease
Effect 4 : ↑ leverage -> increase financial distress -> WACC increase