W2

Question 1

What is capital structure?

Answer 1

The relative proportions of debt, equity, and other securities a firm has outstanding.

Question 2

What is leverage?

Answer 2

The use of debt in a firm’s capital structure.

Question 3

What is the leverage ratio?

Answer 3

Leverage Ratio = Debt / Equity. It measures the proportion of debt to equity.

Question 4

What is unlevered equity?

Answer 4

Equity in a firm with no debt. The shareholders receive all project cash flows.

Question 5

What is levered equity?

Answer 5

Equity in a firm that also has debt. Shareholders are paid after debt holders.

Question 6

What is the market value balance sheet?

Answer 6

A financial statement listing the firm’s assets and liabilities at current market values.

Question 7

What is the Law of One Price?

Answer 7

If two investments generate the same cash flows, they must have the same market value.

Question 8

What is the cost of capital?

Answer 8

The expected return required by investors for providing capital.

Question 9

What happens to a firm’s value in a perfect capital market when capital structure changes?

Answer 9

The firm’s value remains unchanged. It is determined only by the cash flows of its assets, not by financing decisions.

Question 10

Why doesn’t capital structure affect firm value in a perfect capital market?

Answer 10

Because the firm’s financing decisions do not affect the total cash flows or their risk.

Question 11

What is a perfect capital market?

Answer 11

A market where all securities are fairly priced, there are no taxes or transaction costs, and financing decisions do not affect investment cash flows.

Question 12

What is Modigliani and Miller Proposition I?

Answer 12

In a perfect capital market, the total value of a firm’s securities is equal to the market value of its assets and is unaffected by capital structure.

Question 13

Why does Modigliani and Miller Proposition I hold?

Answer 13

Because the total cash flow generated by a firm’s assets remains constant, regardless of how it is divided among debt and equity holders.

Question 14

What is the separation principle in capital structure?

Answer 14

The financing decision does not affect the value of the firm; investment decisions and financing decisions can be separated.

Question 15

What is Modigliani and Miller Proposition II?

Answer 15

The cost of capital of levered equity increases with the firm’s debt-equity ratio.

Question 16

What is the formula for the cost of capital of levered equity (Modigliani and Miller Proposition II)?

Answer 16

rE = rU + (D/E) * (rU - rD), where:
- rE = expected return (cost of capital) of levered equity
- rU = cost of capital of unlevered equity
- rD = cost of debt
- D = market value of debt
- E = market value of equity

Question 17

How does leverage affect equity returns?

Answer 17

Leverage increases the volatility of equity returns, making them more sensitive to changes in firm performance.

Question 18

Why is levered equity riskier than unlevered equity?

Answer 18

Because debt holders are paid first, leaving equity holders with the residual cash flow, which is more uncertain.

Question 19

What is the effect of leverage on systematic risk?

Answer 19

Leverage increases systematic risk and the required risk premium on equity.

Question 20

How do returns differ between unlevered and levered equity?

Answer 20

Unlevered equity has moderate risk and return; levered equity has higher risk and potentially higher return due to financial leverage.

Question 21

What is the formula for Weighted Average Cost of Capital (WACC)?

Answer 21

WACC = (E / (E + D)) * rE + (D / (E + D)) * rD, where:
- E = market value of equity
- D = market value of debt
- rE = cost of equity
- rD = cost of debt

Question 22

What is the unlevered cost of capital?

Answer 22

The cost of capital for a firm with no debt; also equal to WACC in a perfect capital market.

Question 23

What is the formula for unlevered cost of capital?

Answer 23

rU = (E / (E + D)) * rE + (D / (E + D)) * rD

Question 24

Why doesn’t WACC change with leverage in a perfect capital market?

Answer 24

Because the lower cost of debt is offset by the higher cost of equity due to increased risk.

Question 25

What is the formula for unlevered beta?

Answer 25

βU = (E / (E + D)) * βE + (D / (E + D)) * βD, where: - βU = asset (unlevered) beta - βE = equity beta - βD = debt beta - E = equity value - D = debt value

Question 26

What is the formula for levered beta?

Answer 26

βE = βU + (D / E) * (βU - βD), which shows how equity beta increases with leverage.

Question 27

What is the effect of leverage on beta?

Answer 27

Leverage increases the equity beta, reflecting greater exposure to market risk.

Question 28

What is homemade leverage?

Answer 28

When investors borrow or lend on their own to replicate the firm's leverage level.

Question 29

How does homemade leverage support Modigliani and Miller Proposition I?

Answer 29

Because investors can create their desired leverage level, the firm's capital structure does not affect its value.

Question 30

What is arbitrage in the context of capital structure?

Answer 30

Buying undervalued securities and selling overvalued ones to exploit pricing differences and restore MM Proposition I.

Question 31

What is a leveraged recapitalization?

Answer 31

A strategy where a firm issues debt to repurchase equity, increasing financial leverage.

Question 32

How does capital structure affect share price in a perfect capital market?

Answer 32

It does not affect share price because the value of the firm remains unchanged.

Question 33

Why is debt not always better than equity?

Answer 33

Although debt is cheaper, increasing it raises equity risk and cost, leaving WACC unchanged in perfect markets.