w2 : capital structure i

Question 1

state and describe the assumptions of the modigliani & miller model.

Answer 1

perfect capital markets :
- companies & individuals can borrow at same rate
- no taxes, transaction costs, issuance costs
- no liquidation costs
- have fixed investment policy - investment decisions not affected by financing decisions

Question 2

state M&Ms proposition 1.

Answer 2

in pcm, total value of firm equals market value of total cash flows generated by its assets. not affected by choice of capital structure (eg. proportions of debt & equity).

Question 3

state the equation showing M&Ms proposition 1.

Answer 3

E + D = U = A
MV (equity + debt of levered firm) = MV (equity of unlevered firm) = MV (firms assets)

Question 4

what is the law of one price?

Answer 4

firms securities & assets must have same total market value. conservation of value. value remains the same, components / weights may change

Question 5

state M&Ms proposition 2.

Answer 5

cost of capital of levered equity equals cost of capital of unlevered equity plus premium that is proportional to market value D/E ratio

Question 6

state the direct and indirect costs associated with introducing debt.

Answer 6

direct (explicit) - interest payments
indirect (implicit) - increased rate of return required by sh

Question 6

what happens when debt value is increased according to M&M prop 2?

Answer 6

• equity cost of capital increases significantly (reflects risk from equity holders perspective)
• wacc remains constant, since cost of equity increases, but weight decreases

Question 7

state and explain the equation for interest tax shield.

Answer 7

corporate tax rate x interest payments
tax savings stemming from paying interest

Question 8

explain the M&M proposition 1 with taxes.

Answer 8

VL = VU + PV (interest tax shield)
value of levered firm is equal to value of unlevered firm of same risk class plus present value of tax saving

Question 9

state the equation for M&M proposition 1 with taxes.

Answer 9

Vl = Vu + TcD
Vl = value of levered firm
Vu = value of unlevered firm
Tc = tax rate
D = permanent debt
TcD = pv of tax shield on interest payments

Question 10

state the assumptions used when discussing the benefit of using the tax shield.

Answer 10

simplistic - assumes tax rate and permanent debt remains the same for the forseeable future
doesn’t recognise non-debt related tax shields - depreciation, operating losses
taxable earnings - racking up dent + interest payments may reduce earnings to nil, so no tax saving