Corporate Structure

What happens to a firm's cost of capital after a credit downgrade to junk bond status?

A change in debt rating from investment grade to speculative grade will significantly increase the firm's cost of debt capital.

Whats is free cash flow hypothesis?

Higher debt levels discipline managers by forcing them to manage the company efficiently so the company can make its payments and by reducing FCF so there is no misuse of cash.

What is Modigliani & Miller Proposition I without taxes?

I. The market value of a company is not affected by capital structure Managers cannot change the value of the company by using more or less debt, in the absence of taxes.

What is Modigliani & Miller Proposition I with taxes?

I. V_l = V_e + t*D where t*D is the debt tax shield. Alternatively, V_l = EBIT (1 - t) / WACC

What is Modigliani & Miller Proposition II without taxes?

II. The cost of equity is a linear function of the company's debt to equity ratio Debt is less expensive than equity because of seniority (ignoring distress costs). To keep the cost of capital the same for the firm no matter the capital structure (consistently with Proposition I), equity must become more expensive as the proportion of debt is increased within the capital structure.

What is Modigliani & Miller Proposition II with taxes?

II. r_e = r_o + (r_o - r_d)(1 - t)(D / E) r_o - cost of equity of unlevered firm r_e - cost of equity of levered firm r_d - cost of debt

If WACC increases as a result of additional debt, what does it indicate?

If the company's WACC increases as a result of taking on additional debt, the company has moved beyond the optimal capital range. The costs of financial distress may outweigh any tax benefits to the use of debt.

How would an increase in the marginal tax rate impact cost of debt?

It would lower the cost of debt. This relationship can be shown by rearranging the terms of MM Proposition II. r_d = r_o + (r_e - r_o) / (1 - t) (D/E)

What is pecking order theory?

Managers choose methods of financing according to a hierarchy that gives first preference to methods with the least potential information content (internally generated funds - cheapest) and lowest preference to the form with the greatest potential information content (public equity offering - priciest). Internally generated funds are preferable to both new equity and new debt. If internal financing is insufficient, managers next prefer new debt, and finally new equity.

In which markets is the use of long term maturity debt expected the most?

Markets with low inflation. The use of long-maturity debt is expected to be inversely related to the level of inflation.

What is static trade-off theory?

Optimal Capital Structure: V_l = V_u + t*D - PV(Costs of financial distress) The static trade-off theory indicates that there is a trade-off between the tax shield from interest on debt and the costs of financial distress, leading to an optimal amount of debt in a company's capital structure.

How to calculate proportion of debt/equity in capital structure from Debt/Equity ratio?

Proportion of equity = 1 / (D/E + 1) Proportion of debt = 1 - Proportion of equity

What are the attributes of the optimal capital structure?

The capital structure that maximizes the company's stock value is also the capital structure that minimizes its WACC.

What is a common way for a firm to use debt ratings in conjunction with capital structure?

firms set a certain minimum debt rating that the firm strives to stay above at all times.