Capital Structure

Question 1

What is a company’s capital structure?

Answer 1

• mixture of debt and equity company used to finance investments

Question 2

What is the financial goal of the company?

Answer 2

• maximise shareholder wealth
• firm wishes to find capital structure which maximises market value

Question 3

What is MM1 (perfect capital markets)?

Answer 3

Capital structure irrelevance
- in perfect capital markets
- I.e financing decision is irrelevant, investment decision is what is important

Question 4

When is debt good and why?

Answer 4

• debt is good when the company is in a good financial position
• because debt holders have a fixed claim on earnings and the rest belongs to the shareholders

Question 5

Under proposition 1 what is the impact on share price?

Answer 5

• share price is unaffected by capital structure under MM1 as the increase in EPS is offset by the increase in the expected return of the share

Question 6

What is MM2?

Answer 6

• the cost of capital levered equity is equal to the cost of capital unlevered equity plus a premium that is proportional to the debt-equity ratio

rE = rA + D/E (rA-rD)

Question 7

Under MM2 (perfect capital markets) explains what happens when debt increases

Answer 7

• with debt firms financial risk increases and therefore shareholders require higher returns on equity
• when debt increases, equity decreases
• due to increased risk ROE increases
• movements offset each other
  -rA and rD constant

Question 8

In MM with corporate taxes how is debt beneficial

Answer 8

• debt reduces taxable income and increases total income to both stockholders and bond holder

Question 9

What is the formula for interest tax shield?

Answer 9

Interest tax shield= corporate tax X debt
= TcD

Question 10

What is MM’s proposition 1 with corporate taxes?

Answer 10

• the total value of the levered firm exceeds the value of the firm without leverage due to the present value of the tax savings from debt

Question 11

What is the formula for MM’s proposition 1 with corporate taxes?

Answer 11

V(L)=V(U) + PV(interest tax shield)

When debt is permanent:

V(L) = V(U) + TcD

Question 12

What does MM’s proposition 1 with corporate taxes suggest about a firms desired capital structure?

Answer 12

• firms should want as much debt as possible
• in other words debt is advantageous

Question 13

What is the after-tax wacc with corporate taxes?

Answer 13

r(A) = (1-Tc)(D/D+E X r(D)) + (E/E+D)Xr(E))

If debt = 0 r(A) = r(E)