25 Capital Structures

Question 1

Modigliani-Miller Propositions 1

Answer 1

Value of a firm is unaffected by its capital structure

Question 2

Modigliani-Miller Propositions 1 assumptions

Answer 2

1) No taxes, transaction costs, bankruptcy costs
2) Homogeneous expectations
3) Borrowing and lending at risk-free rate
4) No agency costs
5) Investment decisions unaffected by financing decisions

Question 3

Modigliani-Miller Propositions 2

Answer 3

WACC is unaffected by capital structure

Question 4

Modigliani-Miller with taxes

Answer 4

Debt financing creates a tax shield that increases company value

Cost of capital minimized and value of the firm is maximized at 100% debt

Question 5

Cost of financial distress (MM)

Answer 5

1) Legal and administrative fees from bankruptcy
2) Loss of trust, foregone investment opportunities
3) Agency costs of debt: managers represent equity owners

Question 6

Static trade-off theory

Answer 6

A firm’s optimal capital structure is the proportion of debt at which the value of the tax shield from additional borrowing just offsets the increase in costs of financial distress.

Question 7

Agency cost

Answer 7

1) Monitoring cost
2) Bonding cost
3) Residual losses

Question 8

Pecking Order Theory

Answer 8

Managers want to send the least amount of negative signal. And prefer the following sources of capital in order:
1) Retained earnings
2) Debt
3) New equity

Observed capital structure is the result of the manager’s choices over time.

Question 9

WACC

Answer 9

w_dr_d(1-t) + w_e*r_e

Question 10

Debt and equity structures are influenced by

Answer 10

Internal:
1) Industry/company characteristics
2) Debt capacity
3) Corporate tax rate

External:
1) Industry norms
2) Market conditions and business cycle
3) Regulation

Question 11

Company characteristics: Higher portion of debt with stable cash flows

Answer 11

1) Noncyclical
2) Low operating leverage
3) Subscription-based revenue model

Question 12

Company characteristics: Higher portion of debt with collateral

Answer 12

1) Tangible assets
2) Liquid assets
3) Fungible assets

Question 13

Capital structure other

Answer 13

1) Lower cost during business cycle expansions
2) High corporate taxes increase value of tax shield
3) Capital adequacy regulations may require minimum equity

Question 14

Company Life Cycle Stage

Answer 14

1) Start-up stage
2) Growth stage
3) Mature stage