Chapter 14 - Capital Structure (Complex)

Question 1

What is capital structure?

Answer 1

Capital structure is the mix of debt and equity a company uses to finance its operations and investments.

Question 2

What is financial leverage?

Answer 2

Financial leverage refers to the proportion of debt relative to equity in a company’s financing, where higher debt increases potential returns to shareholders but also increases financial risk.

Question 3

What is operating leverage?

Answer 3

Operating leverage is the increase in volatility in operating income caused by fixed costs in a company’s cost structure.

Question 4

How do fixed costs affect operating leverage?

Answer 4

Companies with a high percentage of fixed costs have high operating leverage, meaning small changes in sales can lead to large changes in operating income.

Question 5

Why might firms with high operating leverage prefer lower financial leverage?

Answer 5

Firms with high operating leverage often avoid high debt because volatile operating income increases the risk that they may not be able to meet debt obligations.

Question 6

What is optimal capital structure?

Answer 6

Optimal capital structure is the specific mix of debt and equity that minimizes a company’s weighted average cost of capital (WACC).

Question 7

Why is determining optimal capital structure important?

Answer 7

Identifying the optimal capital structure helps a company minimize its overall cost of capital and maximize firm value.

Question 8

What are the main factors that influence optimal capital structure?

Answer 8

Optimal capital structure depends on the nature of the company’s operations and assets, the amount and cost of available debt, and how adding debt affects the cost of debt and equity.

Question 9

How does adding debt affect the cost of equity?

Answer 9

Adding debt increases financial risk for shareholders, which raises the cost of equity because investors require higher returns for the added risk.

Question 10

What formula shows how the cost of equity changes with leverage?

Answer 10

The Modigliani and Miller Proposition II formula with taxes shows that Re = Ru + (D/E)(Ru − Rd)(1 − T).

Question 11

What does Ru represent in the cost of equity formula?

Answer 11

Ru represents the unlevered cost of equity, which is the return required by shareholders if the company had no debt.

Question 12

What does Rd represent in the cost of equity formula?

Answer 12

Rd represents the company’s cost of debt or the interest rate paid on borrowed funds.

Question 13

What does the D/E ratio represent in capital structure analysis?

Answer 13

The debt-to-equity ratio measures financial leverage by comparing the market value of a company’s debt to the market value of its equity.

Question 14

Why are market values used instead of book values in capital structure calculations?

Answer 14

Market values better reflect the current economic value of debt and equity and therefore provide a more accurate measure of financial risk and cost of capital.

Question 15

What is business risk?

Answer 15

Business risk is the variability of a firm’s earnings caused by industry factors such as technological change, competition, consumer preferences, and economic cycles.

Question 16

What is operating risk?

Answer 16

Operating risk is the volatility in earnings caused by the firm’s cost structure, particularly the balance between fixed and variable costs.

Question 17

How do volatile operating cash flows affect a company’s ability to borrow?

Answer 17

Companies with volatile operating cash flows usually take on less debt because lenders are concerned that the firm may struggle to make required payments.

Question 18

How do tangible assets influence a firm’s ability to obtain debt financing?

Answer 18

Companies with more tangible assets such as property, plant, and equipment can borrow more easily because these assets can be used as collateral.

Question 19

Why is the cost of debt usually lower than the cost of equity?

Answer 19

Debt is less risky for lenders because interest payments are required before shareholder returns, and interest is tax-deductible.

Question 20

How do taxes affect the cost of debt?

Answer 20

Interest payments on debt are tax-deductible, which lowers the after-tax cost of debt for a company.

Question 21

How is the after-tax cost of debt calculated?

Answer 21

The after-tax cost of debt equals the interest rate multiplied by (1 − tax rate).

Question 22

What is financial distress?

Answer 22

Financial distress occurs when a company cannot meet its debt obligations or violates loan covenants, potentially leading to restructuring or bankruptcy.

Question 23

What types of costs arise from financial distress?

Answer 23

Financial distress creates direct costs such as legal and accounting fees and indirect costs such as lost customers, damaged reputation, and employee turnover.

Question 24

How does increasing debt affect the probability of financial distress?

Answer 24

As debt levels rise, the likelihood that a company will struggle to meet its required payments increases, raising the probability of financial distress.

Question 25

How does leverage affect the value of a firm according to Modigliani and Miller Proposition I with taxes?

Answer 25

The value of a leveraged firm equals the value of an unlevered firm plus the tax shield from debt, expressed as VL = VU + TD.

Question 26

Why does adding debt increase firm value under the M&M model with taxes?

Answer 26

Debt increases firm value because interest payments create tax savings that provide a benefit to shareholders.

Question 27

How are financial distress costs incorporated into firm value calculations?

Answer 27

The value of the firm equals the unlevered value plus the tax benefit of debt minus the present value of expected financial distress costs.

Question 28

What is the target capital structure?

Answer 28

The target capital structure is the mix of debt and equity that achieves the lowest WACC and maximizes firm value.

Question 29

Why is identifying the optimal capital structure difficult in practice?

Answer 29

Determining the exact optimal structure is complex because financing costs, market conditions, and company needs change over time.

Question 30

How do companies move toward their target capital structure?

Answer 30

Companies adjust their capital structure over time by issuing debt or equity, repurchasing shares, or paying dividends to shift the debt-equity balance.