Week 5

Question 1

What is capital structure? What will the balance sheet of an unlevered firm look like compared to a levered firm?

Answer 1

Capital structure is a combination of debt and equity. The balance sheet of an unlevered firm consists of assets (A) and liabilities, either in the form of equity (E or S). A levered firm consists of assets (A) and liabilities in the form of equity (E or S) and debt (D or B), overall this sum of liabilities is called V^L.

Question 2

Why is capital structure important for the value of a firm?

Answer 2

The value of a firm is the sum of the value of the firm’s debt and the firm’s equity. If the goal of a firm is to become as valuable as possible, then the firm should pick the debt-equity ratio that makes this value as high as possible.

Question 3

How does the firms capital structure relate to the cost of capital?

Answer 3

The capital structure mix that maximizes the value of the firm is the same as minimizing the firm’s cost of capital.

Question 4

What is business risk?

Answer 4

Business riks is the risk that a company will have lower than anticipated profits, or that it will experience a loss rather than a profit. This business risk does not include financing effects, and is instead only the uncertainty about the future operating income (EBIT).

Question 5

What is financial leverage? How does it relate to financial risk?

Answer 5

Financial leverage is the use of debt, the more debt financing a firm uses in its capital structure, the more financial leverage it employs.
Financial risk is the additional risk concentrated on common stockholders as a result of this financial leverage. It depends only on the types of securities issued, with more debt concentrating business risk on stockholders.

Question 6

What capital structure will firms with higher business risk choose?

Answer 6

A company with higher business risk should choose a capital structure that has a lower debt ratio to ensure it can meet its financial obligations at all times.

Question 7

Why can financial leverage be good and what is the downside?

Answer 7

Financial leverage can dramatically alter the payoffs to shareholders of the firm by potentially multiplying the profits. It can increase the expected return on equity, increase the variability in return on equity (financial risk). Essentially, it is the risk reward tradeoff.

Question 8

What does the effect of financial leverage depend on? how does this relate to the break-even point?

Answer 8

The effect of financial leverage depends on the company’s EBIT. The break-even EBIT is where the leveraged earnings per share equals the unlevered earnings per share. If the EBIT is greater than this the leverage was beneficial, if less then it was not beneficial.

Question 9

How does financial leverage increase shareholder exposure to risk?

Answer 9

The financial leverage exposes shareholders to greater risks because the earnings per share and return on equity become more sensitive to changes in EBIT.

Question 10

Does leverage change the return on assets?

Answer 10

No, leverage changes the earnings per share and return on equity, but not the return on assets.

Question 11

What must be the case for leverage to raise expected return on equity?

Answer 11

For leverage to raise expected return on equity the return on assets must be greater than the cost of the debt, as the debt essentially amplifies the difference between the cost of debt and the return on assets.

Question 12

What is home-made leverage? What does it mean for capital structure?

Answer 12

Despite the effects of financial leverage it is not necessarily true that capital structure is important (M&M imperfection theory), as such the value of a levered firm and unlevered firm is the same. This is because shareholders can adjust the amount of financial leverage by borrowing and lending on their own. This use of personal borrowing to alter the degree of financial leverage to which an individual is exposed is known as home-made leverage.

Question 13

What is homemade un-leverage? How do we do it?

Answer 13

In homemade un-leverage an individual undoes the effect of leveraging by an invested firm by lending to offset the borrowing of the firm.

We undo the leverage by making our bond to stock ratio the same as the firm’s debt to equity ratio.

Question 14

What are the major contributors to value of a firm?

Answer 14

The value of a firm is determined by the cash flows to the firm and risk of the assets. This is detailed in the theory of capital structure, in which firm value, cost of equity, WACC and beta are all considered.

Question 15

What are the assumptions of the base M&M imperfection theory?

Answer 15

In a perfect capital market as assumed by the M&M imperfection theory there is: perfect competition, firms and investors can borrow/lend at the same rate, there is equal access to all relevant information, there are no transaction costs and no taxes.

Question 16

What are our two ways to have leverage in our portfolio as an investor?

Answer 16

The two ways for us to obtain leverage in a stock portfolio are to buy into a levered firm or use home-made leverage.

Question 17

What does the M&M irrelevence theory suggest about the cost of equity for a firm as it increases leverage?

Answer 17

The M&M irrelevance theory suggests that the leverage increases the risk and return to stockholders:

Return on levered equity = return on unlevered equity + (Value of debt/value of levered equity) * (return on unlevered equity - the interest rate).
This suggests that the required rate of return on equity arises from sources of firm risk, which could be business risk or financial risk.

Question 18

How do we calculate WACC?

Answer 18

WACC = proportion of debt * cost of debt + proportion of equity * cost of equity.

Question 19

What does M&M irrelevence theorie ssuggest is the case for the discount rate of unlevered and levered firms?

Answer 19

In the absence of taxes M&M irrelevance theory suggests that the WACC for an unlevered firm, the discount rate for and unlevered firm and the WACC for the levered firm should all be the same. This is because even though our cost of equity increases as we use more debt, our proportion of debt increases. Because the WACC should not change, the financing cost (and firm value) are unaffected by the use of debt.

Question 20

Is systematic risk higher for a firm with leverage or without leverage?

Answer 20

Systematic risk is higher for a firm with leverage than for a firm with no leverage.

Question 21

What is the value of a firm given by? What can we assume about this if we know nothing else?

Answer 21

The value of a firm is just the present value of the cash flows, which we can assume to be a perpetuity if we know nothing.

Question 22

What are the two components that lay claim to the value of a firm? How can we calculate them?

Answer 22

The value of a firm consists of the equity + debt, so the value of equity must be the firm value - debt. If we have the debt to equity ratio of 0.25 we know the value of the firm is made up of 1.25*equity. So we can get the equity value by dividing firm value by 1.25 and then get the value of debt by subtracting the equity from the firm value.

Question 23

When are the value of an unlevered and levered firm the same under M&M irrelevance theory?

Answer 23

The value of an unlevered and levered firm should be the same assuming the same business risk.

Question 24

What is one of the main reasons the M&M irrelevance theory isn’t completely correct in practice?

Answer 24

Corporate tax interest payments are tax deductible, while dividend payments are not, as such debt provides a tax shield benefit for firms. This is a source of additional value for the firm and its shareholders, this additional value becomes part of the shareholders residual claim after debt claims have been met.

This additional value is solely due to the tax deductibility and hence only available for firms with debt. Hence, the value of the firm is increased by the value of the corporate debt tax shield.

Question 25

What does the expanded M&M irrelevence theory rely on?

Answer 25

The M&M theory can be expanded so that all assumptions are held excluding the corporate taxes. This allows for corporate profit taxes and interest is tax deductible.

Personal tax is ignored.

Question 26

Under the M&M irrelevence theory with corporate tax what is the value of a levered firm? Why is this the case with regards to the government?

Answer 26

Under M&M irrelevence theory the value of the levered firm is equal to the value of an unlevered firm in the same risk class plus the fain from leverage (tax rate * debt payments). Essentially, the government takes a smaller slice of the pie.

Question 27

What is the relation between the cost of equity in levered and unlevered firms under the M&M irrelevence theory with corporate taxes?

Answer 27

In M&M theory with corporate taxes the second proposition is that the cost of equity to a levered firm is equal to the cost of equity of an unlevered firm in the same risk class plus a risk premium given by: (unlevered firm cost of equity - cost of debt)*(1-tax rate) * (debt/equity). Hence a levered firm has a higher cost of equity.

Question 28

What occurs to a firm’s WACC under the M&M irrelevence theory with corporate taxes?

Answer 28

In M&M ytheory with corporate taxes the third proposition is that in a world where there is a tax relief on debt interest, a levered firm’s after-tax WACC will be progressively lowered (lowers faster at lower debt levels) as it increases its debt financing, which makes its WACC less than the unlevered firm.

WACC = unlevered cost of equity (1-(debttax rate)/value of the levered corporation).

Question 29

What is the equity beta with relation to the financial leverage?

Answer 29

Equity beta = unlevered beta * (1+ debt*(1-tax rate)/equity

Question 30

What is the value of the levered firm under M&M with corporate taxes in relation to the tax shield?

Answer 30

The value of the levered firm will increase under M&M with corporate taxes, with the difference in value between the levered and unlevered firm being given by the present value of the interest tax shield.

Question 31

How does the WACC and firm value relate?

Answer 31

A lower WACC typically will mean a greater firm value.

Question 32

What is the value of a levered firm with relation the unlevered firm under M&M irrelevence theory with corporate taxes? EBIT

Answer 32

The value of a levered firm under M&M irrelevence theory with corporate taxes is:
value levered = (EBIT*(1- tax rate))/cost of equity for unlevered firm + tax rate * debt.

This assumes EBIT doesn’t change and the interest costs stay the same.

Question 33

Why is taking debt good for holders of equity in many cases?

Answer 33

When there is a tax shield for using debt, holders of equity will benefit more than they will be hindered by the increase in debt.

Question 34

What are the main critiques of M&M irrelevence theory with corporate tax?

Answer 34

The personal tax disadvantage of debt negates its corporate advantage, borrowers also incur costs, such as “bankruptcy costs” and “agency costs” that largely offset the value of the interest tax shield.