week 9

Question 1

what is capital structure

Answer 1

the mix of debt and equity that it uses to finance its activities.

Question 2

what is the optimal capital structure

Answer 2

¡The capital structure which maximises the value of
a company.

Question 3

why do firms borrow if it involves extra risk?

Answer 3

by borrowing, a company may be able to increase the rate of return earned by its shareholders.

this effect is known as financial leverage which is measured by debt-equity ratio or debt-total assets ratio

Question 4

If the rate of return on a company’s assets is greater than the interest rate on its debt

Answer 4

borrowing will increase the rate of return to shareholders.

vice versa

Question 5

Financing a Firm with Equity

nUnlevered Equity

what does this mean

Answer 5

¡Equity in a firm with no debt

nBecause there is no debt, the cash flows of the unlevered equity are equal to those of the project.

Question 6

what happens when the project’s cash flow will always be enough to repay the debt

Answer 6

the debt is risk free and you can borrow at the risk-free interest rate of 5%

Question 7

Modigliani and Miller argued that

Answer 7

with perfect capital markets, the total value of a firm should not depend on its capital structure; the company is independent of its capital structure

Question 8

describe the law of one price

Answer 8

the cash flows of the debt and equity equal to the sum to the cash flows of the project

Question 9

Leverage increases the

therefore?

Answer 9

nthe risk of the equity of a firm.

investors in levered equity will require a higher expected return to compensate for the increased risk.

Question 10

when The project cash flows depend on the overall economy

what exists? what will you do?

Answer 10

market risk

As a result, you demand a 10% risk premium over the current risk-free interest rate of 5% to invest in this project.

Question 11

Leverage increases the risk of equity even when

Answer 11

there is no risk that the firm will default.

Question 12

while debt may be cheaper, its use

_______

Considering both sources of capital together _________

Answer 12

raises the cost of capital for equity

. Considering both sources of capital together, the firm’s average cost of capital with leverage is the same as for the unlevered firm.

Question 13

Modigliani & Miller Analysis

is based on what assumptions?

Answer 13

1. Securities issued by companies are traded in a perfect capital market; this is a frictionless market in which there are no transaction costs and no barriers to the free flow of information.
2. There are no taxes.
3. Companies and individuals can borrow at the same interest rate.
4. There are no costs associated with the liquidation or reorganisation of a company in financial difficulty.
5. Companies have a fixed investment policy so that investment decisions are not affected by financing decisions.

Question 14

MM’s Proposition 1

Answer 14

The market value of any firm is independent of its capital structure

if a company has a given investment policy, then changing its ratio of debt to equity will change the way in which its net operating cash flows generated by assets are divided between lenders and shareholders, but will not change the total value of the cash flows.

• Regardless of how they are divided, their total size remains the same. Therefore, the value of the company’s assets remains the same.
• that the firm’s total cash flows still equal the cash flows of the project, and therefore have the same present value.
• Therefore, the value of the company will not change.

Question 15

Proposition 1: Proof

Answer 15

nTwo companies that have the same assets but different capital structures are, under the assumptions, perfect substitutes. As such, perfect substitutes should have the same value.

Question 16

Proposition 1: Proof

what can investors create?

Answer 16

The proof provided by MM is based on the idea that investors can create homemade leverage

• ¡When investors use leverage in their own portfolios to adjust the leverage choice made by the firm.

¡MM demonstrated that if investors would prefer an alternative capital structure to the one the firm has chosen, investors can borrow or lend on their own and achieve the same result.

Question 17

What if …nThe companies were not selling for the same price?

Answer 17

nArbitrage profits could be earned. An opportunity to make riskless profits exists and arbitragers will exploit this.

Question 18

arbitrage

Answer 18

¡Arbitrage involves buying an asset and simultaneously selling it for a higher price, usually in another market, so as to make a
risk-free profit.

Question 19

if the value of the levered company exceeds the value of the unlevered company,

Answer 19

an investor in the levered company should sell her shares and instead borrow money and invest in the shares of the unlevered company

Question 20

if the value of the levered company exceeds the value of the unlevered company,

what will eventually happen?

Answer 20

If enough investors undertake similar transactions, there will be downward pressure on the price of L shares (because there are many sellers) and upward pressure on the price of U shares (because there are many buyers). Equilibrium will be restored when security prices have adjusted to the point where the market values of the two companies are equal.

Question 21

If a levered company is overvalued, an investor in that company’s shares can

Answer 21

• replicate his risk and return by investing instead in the shares of an unlevered company and adjusting the debt–equity ratio by borrowing personally.
• Hence, leverage does not add value to a levered company because, by borrowing, the levered company is not doing anything that its shareholders cannot do for themselves.

Question 22

if an unlevered company is overvalued, an investor in that company’s shares can

Answer 22

replicate his risk and return by investing instead in the shares of a levered company and adjusting his debt–equity ratio (to zero) by lending personally.

Leverage neither adds to, nor subtracts from, the value of a company.

Question 23

what does arbitrage ensure

Answer 23

ensure that perfect substitutes will not sell at different prices in the same market at the same time.

Question 24

describe substitutes in the context of MM’s analysis

Answer 24

In the context of the MM analysis, two companies with the same assets, but different capital structures, are perfect substitutes.

Question 25

what happens when the market value of two companies are different?

Answer 25

If their market values are not the same, investors will enter the market to take advantage of the arbitrage opportunity and, in doing so, will force the values of the two companies to be the same.

nWe want to show that these two companies are equivalent, otherwise there must be an arbitrage opportunity.

Question 26

Throughout the arbitrage process, the market will

Answer 26

will force returns to be the same, implying the degree of leverage does not have any impact on firm value and can be replicated by investors

Question 27

since the difference between the values of the two companies could not persist, what would happen?

Answer 27

the actions of investors selling L’s securities and buying U’s shares would quickly establish an equilibrium in which their values would be exactly the same.

Question 28

MM’s proposition 2

Answer 28

nThe cost of equity of a levered firm is equal to the cost of equity of an unlevered firm plus a financial risk premium, which depends on the degree of financial leverage:

Question 29

draw the graph of MM’s second proposition

Answer 29

The firm’s overall cost of capital is unaffected by its capital structure.

Question 30

MM Proposition 3:

Answer 30

n: The appropriate discount rate for a particular investment proposal is independent of how the proposal is to be financed
i. e. Whether the investing company obtains the funds by borrowing, or by issuing shares, or both, has no effect on the appropriate discount rate.

nlevel of risk associated with the project.

Question 31

MM proposition 3

The key factor determining the discount rate or a proposal is the

Answer 31

nlevel of risk associated with the project.

Question 32

Taken together, the MM propositions maintain that in a perfect capital market with no taxes,

Answer 32

it is only the investment decision that is important in the pursuit of wealth maximisation. The financing decision is of no consequence.

Therefore, investment decisions can be completely separated from financing decisions.

Question 33

Capital Budgeting and the Weighted Average Cost of CapitalWith no debt, the WACC is

Answer 33

equal to the unlevered equity cost of capital.

Question 34

Capital Budgeting and the Weighted Average Cost of Capital

what happens when the firm borrows at the low cost of capital for debt?

Answer 34

As the firm borrows at the low cost of capital for debt, its equity cost of capital rises. The net effect is that the firm’s WACC is unchanged

Question 35

what does beta show?

Answer 35

The effect of leverage on the risk of a firm’s securities

Question 36

what is unleveraged beta

Answer 36

A measure of the risk of a firm as if it did not have leverage, which is equivalent to the beta of the firm’s assets

Question 37

If the company’s debt is assumed to be risk-free—

what is the beta?

Answer 37

Beta_d= 0

Question 38

what is leveraged beta?

Answer 38

namplifies the market risk of a firm’s assets, β_U, raising the market risk of its equity.

Question 39

what is MM’s analysis also known as

Answer 39

the theory of irrelevance when there are no taxes

Question 40

describe the second proposition of MM’s analysis

Answer 40

As shown in this diagram,

when you increase debt finance, the cost of equity increases as the financial risk of investors increase while cost of debt remains constant

Question 41

describe the second proposition of MM’s analysis

what is the effect of the incrase in the cost of equity?

Answer 41

it offesets the adv of the low cost of the debt

which is WHY the overall cost of capital remains constant

Question 42

what opportunity does arbitrate give investors

Answer 42

the ability to earn riskless profit

Question 43

when may arbitrage be used?

Answer 43

when 2 firms are identical except for their capital strucutre have different market values of cost of capital

Question 44

once again, what does MM theory say?

Answer 44

the capital structure is irrelevant to the cost of capital or market value of the firm and the price of the shares

If there are two firms identical in nature and have different market values, then this situation will not last long b/c arbitrage will take place until the market values are identical

Question 45

according to MM approach, the cost of capital of a firm?

Answer 45

remains constant throughout the project’s life irrespective of the capital structure

Question 46

when 2 firms are identical except for their capital strucutre have different market values of cost of capital

what will happen?

Answer 46

the different won’t last long on the market b/c arbitragers will notice the difference and exploit this arbitrage opportunity

Question 47

describe the MM irrelevant proposition

Answer 47

the weighted average cost of capital (WACC) should remain constant with changes in the company’s capital structure.

For example, no matter how the firm borrows, there will be no tax benefit from interest payments and thus no changes or benefits to the WACC.

Question 48

what does MM2 say?

Answer 48

It says that as the proportion of debt in the company’s capital structure increases, its return on equity to shareholders increase

Question 49

MM 2 says that as the proportion of debt in the company’s capital structure increases, its return on equity to shareholders increase

why?

Answer 49

higher debt levels makes investing in the company more risky, so shareholders demand a higher risk premium on the company’s stock. However, because the company’s capital structure is irrelevant, changes in the debt-equity ratio do not affect WACC

Question 50

nContrast with traditional perspective on capital structure with MM’s approach

Answer 50

1. Low levels of leverage can reduce the weighted average cost of capital.
2. Based on idea that equity holders do not perceive higher risks with low leverage levels.

MM’s analysis refutes this — average cost of capital cannot be reduced by issuing debt.

Question 51

describe the classical tax system

Answer 51

• Applies to the US and foreign companies operating in Australia
• companies and shareholders are taxed independently

Question 52

MM extended their original no-tax analysis to incorporate the effect of company income tax under the classical system

when is company taxed? what are the implications?

Answer 52

Company profit is taxed after allowing a deduction for interest on debt

This means that borrowing causes a significant reduction in company tax and a corresponding increase in the after-tax net cash flows to investors –> incentive to use debt

Question 53

by incorporating taxes under the classical tax system, what happens?

Answer 53

Leverage will increase a firm’s value because interest
on debt is a tax deductible expense

Question 54

by incorporating taxes in the MM analysis, what will happen to personal taxes

Answer 54

reduce the tax advantage associated with debt financing.

Question 55

by incorporating taxes, show the cash flows of levered and unlevered companies

Answer 55

Question 56

MM analysis (with tax)

first proposition says?

Answer 56

Value of a levered firm is equal to the value of an unlevered firm of the same risk class plus the present value of the tax saving

Question 57

MM analysis (with tax)

what does this equation suggest?

Answer 57

levered company is always worth more than an equivalent unlevered company

the more it borrows, the greater is its debt, D, and the more its value increases. If the company tax rate is 30 per cent, then, company value increases by 30 cents for every dollar of debt in a company’s capital structure.

Question 58

MM analysis (with tax)

what factor offsets the adv of debt financing as a way of reducing the company tax payable?

Answer 58

personal tax

Question 59

draw proposition one with company tax

Answer 59

Question 60

describe the 3 implications of miller’s analysis

Answer 60

1. There is an optimal debt–equity ratio for the corporate sector as a whole but not individual company
2. securities issued by different companies will appeal to different types of investors.
3. ¡Shareholders of levered companies end up receiving no benefit from the company tax savings on debt

Question 61

describe the 3 implications of miller’s analysis

first implication is that There is an optimal debt–equity ratio for the corporate sector as a whole but not individual company

why?

Answer 61

the optimal debt–equity ratio will depend on the company income tax rate and on the funds available to investors who are subject to different tax rates.

Question 62

describe the 3 implications of miller’s analysis

2nd implication is that Securities issued by different companies will appeal to different clienteles of investors.

why?

Answer 62

For example, tax-exempt investors should invest only in debt securities, while investors subject to marginal personal income tax rates> company income tax rate should invest only in shares.

Therefore, companies with different capital structures will attract different investor clienteles

Question 63

describe the 3 implications of miller’s analysis

3rd implication: The shareholders of levered companies end up receiving no benefit from the company tax savings on debt because the saving is passed on to lenders in the form of a higher interest rate on debt

Answer 63

• companies are effectively required to compensate the lenders for the additional personal tax payable on interest income –> lenders charge higher interest rate on borrowings

Question 64

the classical tax system taxes

Answer 64

the classical system taxes company income in the hands of the company and then taxes it again when that income is passed on to the company’s shareholders as a dividend.

i.e. double taxation

Question 65

To compare the effects of taxes on debt and equity under an imputation tax system, consider a dollar of EBIT and think of the company’s capital structure as determining whether this dollar is paid out as interest to lenders or used to provide a return to shareholders. The return to shareholders could be in the form of either

Answer 65

dividends or capital gains, depending on whether profit is distributed or retained by the company.

Question 66

if Australian company tax has been paid, then most resident shareholders will benefit if

Answer 66

profits are distributed as franked dividends rather than retained.

Question 67

imputation tax system

If the dollar of EBIT is used to pay interest to lenders, then company tax is

Answer 67

zero because interest paid is tax deductible for the company

Question 68

Incorporating Taxes: Imputation Tax System

how does this work?

Answer 68

income distributed as franked dividends to resident shareholders is effectively taxed only once, at the shareholders’ personal tax rate

¡Interest paid to lenders is only taxed once at lender’s personal tax rate.

the imputation tax system is neutral between debt and equity.

Question 69

Incorporating Taxes: Imputation Tax System

what does neutrality between equity and debt lead to?

Answer 69

we are back to MM’s Proposition 1 in the original no-tax case: the choice of capital structure does not affect a company’s value.

In showing that the imputation tax system can be neutral we have assumed that all profits are distributed as franked dividends.

Other results may be possible if profits are retained.

Question 70

incorporating taxes: imputation tax system

what is the possible bias?

Answer 70

favours equity rather than debt as a source of company finance when personal income tax rates are greater than company tax

Question 71

incorporation taxes: imputation system

does this system favour use of debt?

Answer 71

the Australian imputation tax system does not favour the use of debt finance by companies; it is either neutral or biased towards equity, depending on the investor’s marginal tax rate.

Question 72

incorporation taxes: imputation system

this system is neutral or biased towards equity depending on the investor’s marginal interest rate

what can we conclude?

Answer 72

the same conclusion as Miller:

borrowing will not add value because the interest rate paid will reflect personal tax rates on interest that are equal to or higher than the overall tax rates on equity returns.

it is the structure of the system that makes it neutral or biased towards equity

Question 73

incorporating taxes: imputation system

why may debt have tax advantages for Australian companies with a large overseas ownership?

Answer 73

overseas investors in Australian companies are outside the imputation tax system and are effectively still taxed under the classical system

Question 74

what may financial distress do?

Answer 74

The costs of financial distress may also cause a company’s value to depend on its capital structure.

Question 75

what is financial distress

Answer 75

A company is in financial distress when the company cannot meet its financial obligations or has difficulty meeting it

Question 76

distinguish between serious and less serious cases of financial distress

Answer 76

serious cases –> may lead to the liquidation of the company

• Alternatively, put into receivership –> lenders appoint an administrator or receiver-manager —this may lead either to eventual liquidation or to control reverting to shareholders if the company trades out of its difficulties.

less serious –> company may meet all its commitments but the mere possibility of financial difficulties can change people’s behaviour.

• E.g. suppliers may demand cash on delivery
  *

Question 77

bankruptcy costs

Increasing a company’s debt–equity ratio increases (by borrowing)

how does this influene MM’s analysis and propositions?

Answer 77

increases financial risk for shareholders and also increases the risk that company will default on its debt (“debt is risky”)

• MM’s analysis shows that financial risk increases the cost of equity capital but has no effect on the weighted average cost of capital or on a company’s market value.
• MM’s Proposition 1 holds even if debt is risky: a company’s market value is not affected by its debt–equity ratio

Question 78

When a company issues risky debt there is some probability that

Answer 78

the company will subsequently default, in which case direct bankruptcy costs will be incurred.

Question 79

by issuing risky debt, a company gives outsiders

Answer 79

a potential claim against its assets, which must decrease the value of the company to its shareholders and/or its lenders.

Question 80

nIncorporating the benefits and costs of debt, leads to the following expression of the value of a leveraged firm:

Answer 80

Value of a company

= value of an equivalent all-equity financed company

+ present value of the benefits of debt

– present value of expected bankruptcy costs

V_L = V_U + (PV of debt)

Question 81

The PV of expected bankruptcy costs depends on the

Answer 81

nprobability of bankruptcy and PV of costs incurred if bankruptcy occurs.

Question 82

the probability of bankruptcy increases when?

what trade off does this create?

Answer 82

the present value of expected bankruptcy costs will increase as a company’s debt–equity ratio increase ( the higher the leverage)

decision to borrow creates a trade-off between the advantage of tax savings and the disadvantage of expected bankruptcy costs.

Question 83

in practice do bankruptcy costs exist?

examples of direct and indirect costs

how does this differ from MM’s proposition 1?

Answer 83

there are both direct costs of bankruptcy and indirect costs of financial distress, and these costs will affect companies that issue risky debt

1. direct: mainly legal, accounting fees and fees to liquidators
2. indirect: lost sales, fall in operating efficiency

this shows MM’s assumption that bankruptcy costs are zero (to arrive at the conclusion that market value of firm is unaffected if it holds risky debt) may not prove true in practice

Question 84

indirect costs of financial distress relate to factors such as

Answer 84

the effects of lost sales, reduced operating efficiency and the cost of managerial time devoted to attempts to avert failure.

Question 85

describe the indirect costs of financial distress and give an example

Answer 85

provides incentives for managers and other stakeholders such as customers, suppliers and employees to behave in ways that can disrupt a company’s operating activities and thus decrease its value.

e.g. managers are likely to pay less attention to issues such as product quality (customers respond by buying less –> reduced sales revenue) and employee safety –>

Question 86

due to indirect costs of financial distress, what should a company do?

Answer 86

maintain an image of low-risk

can do this by lowering borrowings

Question 87

what did titman (1984) suggest?

Answer 87

Sales, profits and share price would be greater if the company could assure customers and other stakeholders that it is very unlikely to liquidate.

Titman suggests that the choice of capital structure can, in effect, help to provide this assurance.

By borrowing less, a company decreases the probability of liquidation and hence improves the terms on which it trades with customers and other parties

Question 88

n addition to its adverse effects on sales, a company’s risk of financial distress can also increase

give an example

Answer 88

In addition to its adverse effects on sales, a company’s risk of financial distress can also increase its operating costs and its financing costs.

e.g. a greater risk of financial distress will mean that it is harder to attract and retain skilled employees.

Similarly, it can impair a company’s ability to borrow and to obtain trade credit.

Question 89

other market imperfections:

agency costs

how do agency costs arise

Answer 89

from the potential for conflicts of interest between the parties the company has contractual relationship with e.g. managers, employees, suppliers, shareholders, lenders

Question 90

agency costs

conflicts of interest between lenders and shareholders

When a company borrows, the lenders may fear that ___

Answer 90

When a company borrows, the lenders may fear that managers will make decisions that will transfer wealth from them to shareholders.

Question 91

list the potential areas of conflict between lenders and shareholders

Answer 91

¡Claim dilution

¡Dividend payout

¡Asset substitution

¡Under-investment

Question 92

Conflicts of interest between lenders and shareholders

describe how dividend payout may cause their interests to conflict

Answer 92

If a company significantly increases its dividend payout, it decreases the company’s assets and therefore increases the riskiness of its debt –> transfers wealth from lenders to shareholders

Question 93

Conflicts of interest between lenders and shareholders

describe how dividend payout may increase during financial distress

Answer 93

the incentives for managers to increase a company’s dividends become greater when the company is facing financial distress.

• the dividend payout provides a means for the shareholders to receive returns that otherwise are likely to go to the lenders on liquidation of the company.

Question 94

Conflicts of interest between lenders and shareholders

describe asset substitution as a source of conflict

Answer 94

companies have an incentive to undertake high-risk investments, even when the market value is low and it may have -NPV (so when it is undertaken company will lose value) b/c

if it proves to be succesful, the benefits will be enjoyed be shareholders

If it fails, lenders will bear the costs

so value of shares increase and value of debt falls

Question 95

conflicts of interest between shareholders and lenders

describe underinvestment as a source of conflict

Answer 95

A company may reject proposed low-risk investments that have a positive net present value.

Question 96

conflicts of interest between lenders and shareholders

Lenders should realise that their wealth may be eroded by

what should they do?

Answer 96

managers’ decisions made in the best interests of the company’s shareholders.

lenders can protect themselves from such behaviour by increasing interest rates on debt (especially when the company borrows more)

Question 97

conflicts of interest between lenders and shareholders

when lenders increase interest rate on borrowings to protect themselves, who bears the costs?

Answer 97

it is largely borne by the company’s shareholders

Question 98

conflicts of interest between lenders and shareholders

another way for lender to protect themselves is by

examples include

Answer 98

requiring covenants (contracts) to be included in loan agreements

e.g. restrict additional debt from being issued, limiting dividend payments, company to maintain specific ratios, types of invesments the company can undertake

Question 99

Covenants affect the value of the company and shareholders’ wealth

how

Answer 99

1. monitoring is required to ensure the convenant is not infringed
2. convenants may be too restrictive and prevent managers from pursuing value-maximising decisions e.g. undertaking high-risk, negative NPV projects

Question 100

Conflicts of interest between shareholders and managers

how come?

shareholders have

managers

Answer 100

separation in ownership and control

little or no involvement in the company’s operations

managers conduct the day to day operations of the company

Question 101

Conflicts of interest between shareholders and managers

what is a way to reduce it?

Answer 101

nby aligning the objectives of managers with those of shareholders:

Question 102

Conflicts of interest between shareholders and managers

examples of ways to align shareholders and managers’ objectives

Answer 102

1. employee share ownership schemes
2. the inclusion of options on the company’s shares as part of the remuneration of top-level managers.

Question 103

conflict of interests between shareholders and managers

Would it be best to eliminate the costs associated with the separation of ownership and control by having a company’s equity capital provided only by its managers?

discuss in terms of diversification

Answer 103

No

manager unlikely to reap full benefits of diversification (other shareholders diversify to reduce risk)

managers have skills and knowledge that are company specific (less valuable in other areas) –> require higher rate of return

Question 104

conflict of interests between shareholders and managers

Would it be best to eliminate the costs associated with the separation of ownership and control by having a company’s equity capital provided only by its managers?

discuss in terms of free cash flow

what is free cash flow?

Answer 104

Jensen (1986) cash flow in excess of that required to fund all projects that have positive net present values.

e.g. if company is profitable but industry is declining so there are few positive NPV projects, there will be large free cash flows

Question 105

conflict of interests between shareholders and managers

Would it be best to eliminate the costs associated with the separation of ownership and control by having a company’s equity capital provided only by its managers?

discuss in terms of free cash flow

Answer 105

Jensen (1986) Managers have considerable discretion in deciding how to use free cash flows and

Jensen argues that managers will be tempted to use free cash flows in ways that benefit them rather than the shareholders.

Question 106

conflict of interests between shareholders and managers

Would it be best to eliminate the costs associated with the separation of ownership and control by having a company’s equity capital provided only by its managers?

give examples of how managers how managers may use free cash flow in their interest

Answer 106

invest in new projects or takeovers that increase their command in resources

Question 107

conflict of interest between shareholders and managers

One way to reduce the agency costs of free cash flows is through

why?

Answer 107

dividend payments and share repurchases

Jensen argues that shareholders’ wealth should be increased if managers commit to paying out free cash flow as dividends or to buying back shares rather than retaining the cash within the company.

Question 108

conflict of interest between shareholders and managers

how may debt be beneficial?

Answer 108

shareholders cannot force the manager to pay dividiends or repurchase shares

Debt may be beneficial when companies generate large free cash flows because it forces the payout of cash which reduces the potential for over-investment.

Question 109

conflict of interest between shareholders and managers

there is a tendency for managers to overinvest

when make this be more likely

Answer 109

managers are more likely to overinvest when the company has higher free cash flows

Question 110

Optimal Capital Structure: Trade-Off Theory

what are the pros and cons of debt

what does this lead to?

Answer 110

Pros: interest is tax-deductible

Cons: increased costs of financial distress

the trade off leads to an optimal capital structure. so an optimal capital structure exists and management should aim to maintain a debt-equity ratio

Question 111

optimal capital structure: the static trade off theory

discuss what might happen when an all-equity company decides to issue a small amount of debt,

Answer 111

1. expected costs of financial distress will increase slightly
2. but the savings from interest which is tax-deductible outweighs the risk

so the firm’s value will increase

Question 112

what does the static trade off theory propose?

Answer 112

there is an optimal capital structure (optimal debt-equity ratio) that maximises the value of a company

Question 113

optimal capital structure: the static trade off theory

discuss what might happen when an all-equity company decides to issues more debt

Answer 113

1. expected costs of financial distress increases as the risk of financial distress increases
2. At some point, the higher costs will equal the higher tax savings.

Question 114

optimal capital structure: static trade off theory

what point is the optimal debt-equity ratio

what happens if the debt-equity ratio is increased further?

Answer 114

Companies will borrow until the advantages of additional debt = disadvantages of additional debt.

Adv: tax deduction on interest

Cons: expected costs of financial distress that will arise if the company is unable to pay the interest that it owes.

If the debt–equity ratio is increased still further, the value of the company starts to decrease.

Question 115

what is the static trade off theory

Answer 115

theory that proposes that companies have an optimal capital structure based on a trade-off between the benefits and costs of using debt

there is an optimal debt-equity ratio

Question 116

draw a diagram to describe the optimal capital structure

Answer 116

Question 117

Capital Structure with Information Asymmetry

what is the pecking order theory?

Answer 117

theory that proposes that companies follow a hierarchy of financing sources

1. internal funds are preferred
2. if external funds are needed, borrowing is preferred
3. hybrid securities (converitible notes and preferences shares
4. as a last resort, a new issue
   of ordinary shares.

Question 118

Capital Structure with Information Asymmetry

what can explain the pecking order theory?

Answer 118

Donaldson (1961) explains that it accords to the transaction costs of raising finance e.g. lowest transaction cost by using retained earnings

Myers (1984) it is based on information asymmetry

Question 119

capital structure with information asymmetry

Information asymmetry and the undervaluation of a company’s assets

when is there information asymmetry?

Answer 119

when company managers have more information about their companies’ asset values and prospects than outside investors.

more accurate idea than the share market of the company’s ‘true value’; if it is greater or less than market value

Question 120

capital structure with information asymmetry

Information asymmetry and the undervaluation of a company’s assets

provide an example

Answer 120

company issues 100,000 shares at market value of 4.50

short term (before sharemarket learns of the true value): information asymmetry between shareholders and managers; managers know that the true value of the shares is 5, greater than the market believes

• investment opportunity 200k outlay and 17k NPV, not known by outsiders and not reflected in share price (second information asymmetry)

Long term (after share market learns of the true value): more info available, share market will also value shares as 5

market informed of the investment –> share price rises

Question 121

capital structure with information asymmetry?

what are the 4 alternative information and financing methods?

Answer 121

1. investment announcement made before the share market learns the true value of the existing assets; new shares are issued

2. investment announcement made before the share market learns the true value of the existing assets; new shares are issued

3. investment announcement made before the share market learns the true value of the existing assets; new debt is issued

4. investment announcement made before the share market learns the true value of the existing assets; new debt is issued

Question 122

capital structure with information asymmetry

what is the best option?

Answer 122

investment announcement made before the share market learns the true value of the existing assets

the new investment project should be accepted immediately, and should be financed by debt.

Question 123

capital structure with information asymmetry

what is the worst option?

Answer 123

investment is undertaken immediately and is financed by shares; investment announcement made before the share market learns the true value of the existing assets; new shares are issued

It is so bad that in the long term the shareholders lose as a result of undertaking an investment with a positive NPV.

Question 124

implications of information asymmetry for financing policy

what does information symmetry cause

Answer 124

shares to be under or overvalued in the share market

Question 125

implications of information asymmetry for financing policy

what will a manager do when a share price is overvalued and undervalued?

Answer 125

if a company’s managers believe that its shares are undervalued, they will prefer to borrow.

If they believe that the shares are overvalued, they will prefer to issue new shares.

Question 126

why do new issues rank low in the pecking order?

Answer 126

b/c shareholders’ understand manager’s motives

if manager announces new share issue –> evidence that the company’s managers know bad news that is not yet known to outsidere i.e. the current share price is overvalued

so the share price will decrease when a new share issue is announced

Question 127

capital structure with information asymmetry

what is the main implication for company managers?

Answer 127

since it is best for the company to accept a new project immediately and finance it by debt, they will need quick access to debt when there is a profitable investment opportunity –> reduce financial leverage

Question 128

capital structure with information asymmetry

the company needs to have low leverage to access debt finance quickly

what if the company has high leverage?

Answer 128

high leverage, can only meet unexpected need for funds by issuing shares

shareholders believe managers are concealing something –> announcement causes company share price to fall (unless manager can convince shareholders they are not concealing adverse info)

Question 129

capital structure with information asymmetry

the company needs to have low leverage to borrow at short notice instead of resorting to issuing shares immediately

how can the company ensure they have low leverage

Answer 129

by restricing debt to moderate levels

marketable securities that can be sold to provide cash and/or arranging lines of credit with unused borrowing limits.

Question 130

main difference between pecking order theory and the static trade-off theory

Answer 130

pecking order theory does not rely on the concept of a target debt–equity ratio

Instead, a company’s observed capital structure will simply reflect the history of its capital requirements.

Question 131

pecking order theory does not rely on the concept of a target debt–equity ratio

Instead, a company’s observed capital structure will simply reflect the history of its capital requirements.

give an example

Answer 131

a company enjoys exceptional profitability, which results in a substantial increase in its share price. Therefore, in market value terms, the company’s debt–equity ratio will have decreased.

Question 132

main difference between pecking order and static trade off theory

if a company’s capital structure has not changed according to the static trade theory,

Answer 132

if a company’s optimal capital structure has not changed, then the company’s next capital raising should be debt, to move back towards the target debt–equity ratio.

Question 133

main difference between pecking order and static trade off theory

what does the pecking order suggest if the company is profitable?

Answer 133

it may not need to raise external funds at all.

• profitable companies will tend to have low debt–equity ratios because of the availability of internal funds.
• Less profitable companies in the same industry will have higher debt–equity ratios because they generate fewer funds internally and because debt is first on the pecking order of external sources of funds.

Question 134

Jensen’s Free Cash Flow Theory

Information asymmetry implies

Answer 134

that reserve borrowing capacity is valuable.

Question 135

Jensen’s Free Cash Flow Theory

Reserve borrowing capacity is more valuable for

Answer 135

high growth companies. In more mature, stable companies it can cause free cash flows.

Question 136

jensen’s free cash flow theory

what is slack for management

Answer 136

Where reserve borrowing capacity results in free cash flows, it offers slack for management.

Question 137

information asymmetry

The problem of being forced to choose between forgoing a positive NPV project and seeing the share price fall because of a share issue can be overcome by

Answer 137

by maintaining ‘reserve borrowing capacity’ or ‘financial slack’ –> additional finance can always be raised at short notice to take advantage of profitable investments.

Question 138

when there is information asymmetry between managers and investors, the announcement of a new share issue is likely to

Answer 138

cause share prices to fall

Therefore, if a company needs to issue new shares to finance a new project, the overall effect can be a reduction in shareholders’ wealth, even though the project has a positive net present value.

Question 139

what are the implications of share price –> reduction in shareholders’ wealth after immediately announcing a share issue?

Answer 139

information asymmetry can effectively force companies to follow a financing pecking order in which internal funds are the first choice and external equity is the last choice.

Question 140

what industries are likely to generate large free cash flows?

what are the implications

Answer 140

profitable companies in mature industries are likely to generate large free cash flows and managers may invest these cash flows in ways that benefit them rather than the shareholders.

BUT Jensen pointed out that debt can provide a solution to this overinvestment problem because it forces managers to pay out cash

Question 141

While financial slack is valuable for some companies, it is not valuable for all companies.

why?

Answer 141

company that is very profitable but operates in an industry with few investment opportunities.

If this company has a low debt–equity ratio, it will have considerable financial slack. However, it will also have a large free cash flow, so there is a danger that its managers may squander resources on takeovers or diversification projects that benefit them but harm the shareholders.

Question 142

jensen’s free cash flow theory

what does he suggeest about reserve borrowing capacity?

Answer 142

may not generate adequate returns and should be paid out to investors rather than retained in the company.

Jensen (1986) argues that free cash flows should be paid out to investors in order to avoid poor use of funds by managers.

Debt offers a ‘control effect’ generating a credible commitment not to misuse free cash flow, as it is required to service debt

Question 143

Market Timing Theory by Baker & Wurgler (2002)

nFirms tend to issue equity instead of debt when:

Answer 143

¡market value (relative to book value and past market values) is high.

¡Cost of equity is relatively low

¡Investors are too enthusiastic about earnings prospects.

Question 144

Market Timing Theory by Baker & Wurgler (2002)

nFirms tend to buyback shares when

Answer 144

¡market value (relative to book value and past market values) is low,

¡Cost of equity is relatively high.

Question 145

Market Timing Theory by Baker & Wurgler (2002)

Graham & Harvey’s (2001) survey shows that

Answer 145

n2/3 of CFOs admit the importance of market timing in issuing equity.

Question 146

Assessing Theories of Capital Structure: Trade-Off Theory

what does the trade-off theory propose?

Answer 146

It proposes that companies should borrow until the marginal tax advantage of additional debt is exactly offset by the increase in the present value of the expected costs of financial distress.

Question 147

Assessing Theories of Capital Structure: Trade-Off Theory

what did myers argue?

Answer 147

Myers’ argument is that the static trade-off theory does not explain why companies are generally conservative in using debt finance

Question 148

Assessing Theories of Capital Structure: Trade-Off Theory

give an example to explain myers argument

Answer 148

many large profitable companies such as Microsoft and the major pharmaceutical companies have operated for years with low debt ratios.

These companies have high credit ratings and could achieve significant interest tax savings by increasing their debt ratios without the probability of financial distress becoming more than remote.

Question 149

limitations to the trade-off theory

Answer 149

1. Cannot explain why companies are generally conservative in using debt finance.

2.Negative relationship between leverage and profitability
is not explained by trade-off theory.

3. Cannot explain similar leverage levels across countries with different tax systems.
4. Expect leverage to be higher in the US, where a classical tax system applies

Question 150

how is the negative relationship between profitiabilty and leverage explained by the trade off theory according to myers?

Answer 150

High profitability means that the firm has more taxable income to shield, and that the firm can service more debt without risking financial distress

Question 151

limitation to trade-off theory is that the trade-off theory does not explain similar leverage levels under different tax systems

expalin

Answer 151

If corporate borrowing has a significant tax advantage, as proposed by the static trade-off theory, then leverage should be higher in the US with its classical tax system than in other countries with imputation tax systems

Question 152

assessing theories of capital structure: pecking order theory

what is the leverage like in high-growth, high-tech companies why?

Answer 152

leverage is typically low in high-technology industries where there are large growth opportunities and large needs for external finance

b/c they have mostly intangible assets and would therefore find debt very expensive. Further, heavy borrowing by such companies should expose them to the underinvestment problem.

Question 153

describe the underinvestment problem

Answer 153

a company, or the shareholders of a company, choose not to invest in low-risk investments to maximise their wealth (they invest in high-risk, higher profit assets)

• low-risk investments would provide a safe cash flow to lenders
• The safe cash flow does not generate an excess return for the shareholders. As a result, the project is rejected, despite increasing the overall value of the company
• increases shareholders’ value at the expense of lenders

Question 154

describe ther relationsihp between the manager and shareholder

and what the manager is supposed to do

Answer 154

The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximizeshareholder wealth.

However, it is in the manager’s own best interest to maximize his own wealth

Question 155

what is the asset substitution problem

Answer 155

A problem that arises when a company exchanges its low-risk assets for high-risk investments.

This substitution transfers value from a firm’s bondholders to its shareholders.

Question 156

explain the asset substitutin problem

Answer 156

1. The transfer of assets places more risk on the debt holders without providing them with additional compensation.
2. High-risk projects can yield higher profits, however more risk is incurred by the firm.
3. The added profit may only benefit the shareholders, as the bondholders require only a fixed return.
4. The increased risk affects the bondholders, since the company increases its chance of defaulting on its debt.

Question 157

Assessing Theories of Capital Structure: Free Cash Flow Theory

Answer 157

1. Reflects conflict of interest between managers and shareholders.
2. potential to be misused by management (Jensen) Wants to prevent managers from investing in low-return projects.
3. High leverage forces company to pay out cash and adds value by preventing unprofitable investment.
4. Primarily applicable to companies with high free cash flows and poor investment opportunities — typically
   ‘mature cash-flow firms

Question 158

The financing strategy should complement the investment strategy and take into consideration

Answer 158

¡Business risk.

¡Asset characteristics.

¡Tax position.

¡Maintenance of reserve borrowing capacity.

¡Other factors such as political and inflation risk.

Question 159

describe MM’s irrelevance proposition

simplified version given their assumptions

Answer 159

the weighted average cost of capital (WACC) should remain constant with changes in the company’s capital structure.

• no matter how the firm borrows, there will be no tax benefit from interest payments and thus no changes or benefits to the WACC.
• since no changes or benefits from debt increases, the capital structure does not influence a company’s stock price, and the capital structure is therefore irrelevant to a company’s stock price.

Question 160

describe MM II

Answer 160

The existence of higher debt levels makes investing in the company more risky, so shareholders demand a higher risk premium on the company’s stock.

However, because the company’s capital structure is irrelevant, changes in the debt-equity ratio do not affect WACC

Question 161

MM II with corporate taxes state

Answer 161

MM II with corporate taxes acknowledges the corporate tax savings from the interest tax deduction –> changes in the debt-equity ratio do affect WACC.

Therefore, a greater proportion of debt lowers the company’s WACC.

Question 162

MM’s analysis implied that in a perfect capital market, allcapital structure decisions are unimportant made under the assumptions.

When make capital structure decisions be relevant?

Answer 162

it may be relevant by taking into account the factors MM excluded by the assumptions

Question 163

when may there be overinvestment?

Answer 163

conflict between mangers and shareholders’ interest where managers make investments for their own benefit

Question 164

underinvestment can be severe for what kind of companies? why?

Answer 164

underinvestment problem can be severe for growth companies it should not be significant for mature companies with few profitable investment opportunities.

• The value mature companies comes mostly from assets in place that can be used as security for debt

Question 165

underinvestment problem

why should growth companies restrict their leverage?

Answer 165

they lack tangible assets so

1. debt is both difficult and expensive to obtain
2. if it gets into financial difficulty, there are costs of invesments forgone

Question 166

which is more difficult to add value to the company? financing or investment decisions? and why?

Answer 166

it is usually harder to add value by making good financing decisions than by making good investment decisions.

While a company may be able to find investment projects with positive NPVs, the highly competitive nature of financial markets means that it is much more difficult to make financing decisions that have positive net present values.

Question 167

why are investment decisions important?

Answer 167

the primary source of a company’s value is the cash flows generated by its assets.

Question 168

given the primacy of investment decisions, it seems sensible to suggest that

Answer 168

a company’s financing strategy should be designed to complement and support its investment strategy

Question 169

while it is not easy to add value by making good financing decisions…..

Answer 169

while it is not easy to add value by making good financing decisions, it is certainly possible to reduce value by making poor financing decisions

Question 170

describe an example of how poor financing decisions can reduce value

Answer 170

a high proportion of debt can reduce shareholders’ wealth because the expected bankruptcy costs become significant.

Question 171

The probability of bankruptcy depends

Answer 171

partly on the company’s ability to meet its fixed financial commitments. By issuing debt, the company increases these financial commitments, and hence also increases its probability of bankruptcy.

Question 172

what should a manager take into account when gauging the bankruptcy cost implications of issuing (more) debt?

Answer 172

the variability of future cash flows

The greater the variability of cash flows from its assets, the greater is the probability that, at some future time, the company will be unable to meet its financial commitments.

Question 173

how may tangible and intangible assets determine how much can be borrowed?

Answer 173

tangible assets can be sold more easily

companies with a high proportion of tangible assets would be able to borrow more than companies that have a high proportion of intangible assets.

Question 174

distinguish between general-purpose and company-specific assets

Answer 174

general-purpose assets: can be easily deployed for alternative purposes e.g. motor vehicle

company specific assets: worth much more in their current use than in any alternative uses e.g. highly specialised equipment

Question 175

how can general-purpose and company-specific assets determine how much a company can borrow

Answer 175

General-purpose supports higher proportion of debt borrowing

company-specific less b/c company-specific assets it will lose much of their value if the borrower defaults and is liquidated SO expectedbankruptcy costs are high –> higher interest rate

Question 176

how is company tax recovered under the imputation system?

Answer 176

company tax paid is effectively recovered by shareholders through receipt of franked dividends

Question 177

how are non-residents taxed under the imputation system

Answer 177

non-residents cannot franking dividend; they are taxed under the classical system

Question 178

why should a company’s financial strategy be designed to complement its investment strategy?

Answer 178

Because a company’s value depends primarily on the cash flows generated by its assets

Question 179

what happens when perfect capital market assumptions are relaxed?

Answer 179

When the perfect capital market assumptions are relaxed, several factors could make capital structure important e.g. company income tax, personal income tax, the costs of financial distress, agency costs and information asymmetry.

Question 180

distinguish how changing the capital structure under a classical/imputation system can influence the value of a company

Answer 180

classical system: increase in borrowings –> increase in interest –> interest is tax-deductible –> reduces company tax. This will add value if the company tax saved > personal income tax

imputation tax system: removes tax adv of debt

Question 181

What are the potential advantages and disadvantages to a company’s shareholders if the company increases the proportion of debt in its capital structure?

Answer 181

Pro: may increase the returns to the company’s shareholders

Con: increases the risk of an investment in the company’s shares

MM analysis shows that any increase in shareholders’ wealth (when increase in wealth outweighs risk) can arise only from taxes or imperfections such as agency costs.

Question 182

business risk

Answer 182

is the risk inherent in a company’s operations, and will depend largely on the industries in which the company operates.

Question 183

financial risk

Answer 183

additional risk to which shareholders are exposed due to a company’s use of debt finance

Question 184

Default risk

Answer 184

risk that a borrower may fail to make the repayments that are due to lenders.

Question 185

Proposition 2: This is expressed as an equation as

Answer 185

K_e = K₀ + (K₀ - K_e) D/E

for a levered company, the cost of equity capital consists of:

(i) k₀, which is the rate of return that investors require based on a company’s business risk;
(ii) an increment for financial risk which is proportional to the company’s debt–equity ratio and depends on the difference between k₀ and kd.

Question 186

Outline Miller’s argument that the tax advantages of debt are reduced or completely offset once personal taxes are included in the analysis. How appropriate is Miller’s analysis, given the Australian tax system?

Answer 186

most taxpayers do pay tax at a higher rate on income from debt than on income from shares. In addition, there are some investors who pay no tax on income from financial assets

Miller’s analysis was appropriate to Australia under the classical tax system, because the effective tax rate on income from debt was higher than that on income from shares, MM’s analysis does not apply in the imputation system

Question 187

An investor will wish to invest in a company because of its capital structure. Discuss this statemet

Answer 187

if the personal tax on equity returns is zero, but interest on debt is taxed at the rate tp, then investors whose tp > tc (where tc = company income tax rate) would prefer to invest only in shares, while investors whose tp < tc would prefer to invest only in debt. This is one type of ‘clientele effect’

Question 188

for investors with personal tax rates greater than the company tax rate, there can be an incentive to

Answer 188

retain, rather than distribute, profits.

Question 189

Costs of financial distress will be borne entirely by lenders?

Answer 189

no

while realised liquidation costs are borne by debtholders (when equity becomes worthless), expected liquidation costs will be borne by shareholders (higher interest rate lenders charge to compensate)

Question 190

t is obvious that companies should use as much debt as possible. It is cheaper than equity and the interest is tax deductible as well.

discuss

Answer 190

debt appears to be cheaper than equity—that is, kd < ke.

However, the interest cost of debt is only its explicit cost. Borrowing creates financial risk which causes the cost of equity capital to increase

Question 191

. The fact that companies are allowed a tax deduction for interest would give debt an advantage if

Answer 191

income to investors in both debt and equity were taxed at the same rate. However, Miller points out that, generally, personal tax on debt is greater than that on equity.

He argued that this differential could exactly offset the tax deductibility of interest.

Question 192

The probability of financial distress should be negligible for companies with a low proportion of debt. Therefore, a low proportion of debt should not have any noticeable effect on the cost of equity.

Answer 192

While the risk of financial distress may be negligible, any borrowing creates financial risk, and the MM analysis shows that shareholders will require compensation for that risk—that is, the cost of equity will increase as shown by their Proposition 2.

Question 193

Outline the characteristics you would expect a company to have if it had:

a very low debt–equity ratio

Answer 193

likely to have a relatively low taxable income, a preponderance of illiquid assets such as intangible and/or company-specific assets, and operate in a high-risk industry.

Also, most companies in the early years of their operation are likely to use relatively small amounts of debt.

Question 194

Outline the characteristics you would expect a company to have if it had:

a very high debt–equity ratio.

Answer 194

likely to have high and stable earnings, a preponderance of tangible, marketable assets, and operate in a low-risk industry

Question 195

Would you necessarily expect companies in the same industry to have similar debt–equity ratios? Give reasons for your answer.

Answer 195

they have similar business risk.

However, companies in the same industry (for example, retailing) also operate with very different debt–equity ratios, which suggests that factors other than business risk are important in determining a company’s debt–equity ratio.

For example, since cash inflows are often used to repay debt, a more profitable company is likely to have a lower debt–equity ratio than other less-profitable companies in the same industry.

Question 196

Suppose that the government substantially reduced the company tax rate in a classical tax system.

What would the Modigliani and Miller (with company tax) approach suggest about the effect of this change on the capital structures of companies?

Answer 196

The substantial reduction in the company income tax rate would not change the underlying principle of the MM analysis (with company tax)—that is, the value of a company can be increased by increasing the amount of debt in its capital structure.

Question 197

Suppose that the government substantially reduced the company tax rate in a classical tax system.

What would Miller’s model predict about the effect on:

the quantity of debt for the corporate sector as a whole

Answer 197

With the reduction in the company income tax rate, the tax savings per dollar of debt will be lower; therefore, under the classical tax system, the quantity of debt should decline.