Reading 31: Capital Structure

MM Proposition II (no taxes)

- Cost of equity increases linearly as debt proportion increases: debt financing increases --> decreases cash flow to residual claimers (equity holders) --> increase risk of holding equity --> cost of equity increases - Cost of equity increases linearly with the debt-to-equity ratio.

Factors affecting capital structure decisions (violations of MM proposition assumptions)

- Debt ratings: cost of borrowing varies for different firms based on creditworthiness rating. Lenders measure creditworthiness based on book values instead of market values - Cost of asymmetric information: managers keeping information from lenders and investors --> higher cost of asymmetric information --> higher cost of capital - Net agency costs of equity: owners keeping managers from acting against their interest by incurring monitoring, bonding and residual losses costs. Higher debt level reduces agency costs by reducing the amount of free cash flow available for managers.

Holding operating earnings constant, an increase in the marginal tax rate to 40% would: A. result in a lower cost of debt capital. B. result in a higher cost of debt capital. C. not affect the company's cost of capital.

A. A is correct. The after-tax cost of debt decreases as the marginal tax rate increases.

Which of the following is least likely to be true with respect to optimal capital structure? A. The optimal capital structure minimizes WACC. B. The optimal capital structure is generally close to the target capital structure. C. Debt can be a significant portion of the optimal capital structure because of the tax-deductibility of interest.

B. B is correct. A company's optimal and target capital structures may be very different from one another.

Which of the following is least likely to be true with respect to agency costs and senior management compensation? A. Equity-based incentive compensation is the primary method to address the problem of agency costs. B. A well-designed compensation scheme should eliminate agency costs. C. High cash compensation for senior management, without significant equity-based performance incentives, can lead to excessive caution and complacency.

B. B is correct. A well-designed management compensation scheme can reduce, but not eliminate, agency costs.

Which of the following is true of the growth stage in a company's development? A. Cash flow is negative, by definition, with investment outlays exceeding cash flow from operations. B. Cash flow may be negative or positive. C. Cash flow is positive and growing quickly.

B. B is correct. Cash flow typically turns positive during the growth stage, but it may be negative, particularly at the beginning of this stage.

Which of the following is an example of agency costs? In each case, management is advocating a substantial acquisition, and management compensation is comprised heavily of stock options. A. Management believes the acquisition will be positive for shareholder value but negative for the value and interests of the company's debtholders. B. Management's stock options are worthless at the current share price. The acquisition has a high (50%) risk of failure (with zero value) but substantial (30%) upside if it works out. C. The acquisition is positive for equityholders and does not significantly impair the position of debtholders. However, the acquisition puts the company into a new business where labor practices are harsh and the production process is environmentally damaging.

B. B is correct. Management is advocating an acquisition that is likely to be positive for the value of the company's options but negative for equityholders given the substantial risk. A is an example of the debt-equity conflict. C is an example of stakeholder interests that are not being considered by management.

Which of the following is least accurate with respect to debt-equity conflicts? A. Equity holders focus on potential upside and downside, while debtholders focus primarily on downside risk. B. Management attempts to balance the interests of equity holders and debtholders. C. Debt covenants can mitigate the conflict between debtholders and equityholders.

B. B is correct. Management is generally focused on maximizing the value of equity.

According to the static trade-off theory: A. debt should be used only as a last resort. B. companies have an optimal level of debt. C. the capital structure decision is irrelevant.

B. B is correct. 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.

Which of the following stakeholders are least likely to be positively affected by increasing the proportion of debt in the capital structure? A. Senior management B. Non-management employees C. Shareholders

B. B is correct. While leverage increases risk for all stakeholders, shareholders generally benefit through higher potential returns. Senior management typically benefits through equity-based compensation. For non-management employees, equity-based compensation is likely to be small to non-existent.

Compared with managers who do not have significant compensation in the form of stock options, managers who have such compensation will be expected to favor: A. less financial leverage. B. greater firm risk. C. issuance of common stock.

B. Given the asymmetric returns on stock options, we would expect managers with significant stock options in their compensation to favor greater financial leverage and issuance of debt to increase potential stock price gains. Issuing common stock could decrease the market price of shares, which would decrease the value of stock options.

Which of the following best describes the free cash flow hypothesis? A. Unequal information distribution exists between management and other stakeholders. B. Higher debt levels discipline managers by forcing them to manage the company efficiently. C. Managers choose methods of financing according to a hierarchy that gives first preference to methods with the least potential information content.

B. Statement A describes asymmetric information. Statement B describes the free cash flow hypothesis. Statement C describes the pecking order theory.

Vega Company has announced that it intends to raise capital next year, but it is unsure as to the appropriate method of raising capital. White, the CFO, has concluded that Vega should apply the pecking order theory to determine the appropriate method of raising capital. Based on White's conclusion, Vega should raise capital in the following order: A.debt, internal financing, equity. B.equity, debt, internal financing. C.internal financing, debt, equity.

C. According to the pecking order theory, managers prefer internal financing. If internal financing is insufficient, managers next prefer debt, then equity in order of increasing visibility to outsiders.

Which of the following mature companies is most likely to employ a high proportion of debt in its capital structure? A. A mining company with a large, fixed asset base B. A software company with very stable and predictable revenues and an asset-light business model C. An electric utility

C. C is correct. An electric utility has the capacity to support substantial debt, with very stable and predictable revenues and cash flows. The software company also has these attributes, but it would have been much less likely to have raised debt during its development and may have raised equity. The mining company has fixed assets, which it would have needed to finance, but the cyclical nature of its business would limit its debt capacity.

Which of the following is most likely to occur as a company evolves from growth stage through maturity and seeks to optimize its capital structure? A. The company relies on equity to finance its growth. B. Leverage increases as the company needs more capital to support organic expansion. C. Leverage increases as the company is able to support more debt.

C. C is correct. As cash flows become more predictable, the company is able to support more debt in its capital structure; the optimal capital structure includes a higher proportion of debt. While mature companies do borrow to support growth, this would typically not occur because the company is optimizing its capital structure. Likewise, while a mature company might issue equity to finance growth, this would not be the typical approach for a company optimizing its capital structure.

Which of the following is not a reason why target capital structure and actual capital structure tend to differ? A. Financing is often tied to a specific investment. B. Companies raise capital when the terms are attractive. C. Target capital structure is set for a particular project, while actual capital structure is measured at the consolidated company level.

C. C is correct. Companies generally raise finance when capital is needed, such as for investment spending or when market pricing and terms are favorable for debt or equity issuance.

Which of these statements is most accurate with respect to the use of debt by a start-up fashion retailer with negative cash flow and uncertain revenue prospects? A. Debt financing will be unavailable or very costly. B. The company will prefer to use equity rather than debt given its uncertain cash flow outlook. C. Both A and B.

C. C is correct. For a start-up company of this nature, debt financing is likely to be unattractive to lenders—and therefore very expensive or difficult to obtain. Debt financing is also unappealing to the company, because it commits the company to interest and principal payments that might be difficult to manage given its uncertain cash flow outlook.

The current weighted average cost of capital (WACC) for Van der Welde is 10%. The company announced a debt offering that raises the WACC to 13%. The most likely conclusion is that for Van der Welde: A. the company's prospects are improving. B. equity financing is cheaper than debt financing. C. the company's debt/equity has moved beyond the optimal range.

C. C is correct. 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.

Other factors being equal, in which of the following situations are debt-equity conflicts likely to increase? A. Financial leverage is low. B. The company's debt is secured. C. The company's debt is long-term.

C. C is correct. Long-term debt is more exposed than short-term debt to the risk of a management decision that is not debtholder-friendly. Secured debt is less exposed than unsecured debt to such a risk, and with low leverage, the risk of debt-equity conflict is reduced, not increased, relative to high leverage.

Which of the following is least accurate with respect to the market value and book value of a company's equity? A. Market value is more relevant than book value when measuring a company's cost of capital. B. Book value is often used by lenders and in financial ratio calculations. C. Both market value and book value fluctuate with changes in the company's share price.

C. C is correct. Share price changes will cause the market value of the company's equity to change; book value is unaffected.

Which of the following is least likely to affect the capital structure of Longdrive Trucking Company? Longdrive has moderate leverage today. A. The acquisition of a major competitor for shares B. A substantial increase in share price C. The payment of a stock dividend

C. C is correct. Stock dividends, like stock splits, have no impact on the value of a company's equity. Issuing shares to acquire a competitor would increase equity relative to debt in the capital structure. Share price appreciation would also increase the market value of equity, thus increasing equity relative to debt.

According to Modigliani and Miller's Proposition II without taxes: A. the capital structure decision has no effect on the cost of equity. B. investment and the capital structure decisions are interdependent. C. the cost of equity increases as the use of debt in the capital structure increases.

C. The cost of equity rises with the use of debt in the capital structure (e.g., with increasing financial leverage).

To determine their target capital structures in practice, it is least likely that firms will: A. use the book value of their debt to make financing decisions. B. match the maturities of their debt issues to specific firm investments. C. determine an optimal capital structure based on the expected costs of financial distress.

C. While it is a useful theoretical concept, in practice determining an optimal capital structure based on the cost savings of debt and the expected costs of financial distress is not feasible. Because debt rating companies often use book values of debt, firms use book values of debt when choosing financing sources. A is incorrect. It is common for firms to match debt maturities to the economic lives of specific investments. B is incorrect

MM Proposition II (with taxes)

Cost of equity is a linear function of cost of debt adjusted for tax. --> Cost of equity rises at a slower pace with taxes --> WACC decreases as D/E increases

Pecking Order Theory

Firm follows a hierarchy of financing that begins with retained earnings, which is followed by debt financing and finally external equity financing - This order results from firm wanting to send more positive signals to investors

MM Proposition Assumptions

Investors have homogeneous expectations, which means they agree on the expected cash flows from an investment. Perfect capital markets. There are no transaction costs, no taxes, and no bankruptcy costs. Everyone has access to the same information. Riskless borrowing: borrowing and lending at risk-free rate No agency costs: Managers always act in the best interest of the investors, maximizing shareholder wealth. Financing and investment decisions are independent.

Company's life cycle

Start-up stage: Negative cash flow, equity financed, high business risk, no debt Growth stage: Cash flow rising but can be negative, secured debt available moderate business risk Mature stage: Positive cash flow, low business risk, use of both secured and unsecured debt, D/E falls as maturity grows.

Target vs Optimal capital structure

Target capital structure may differ from optimal level: - Different opportunities make certain source of financing more attractive: rise in firm stock will make issuing equity more attractive - Market values of debt and equity fluctuate: capital weights depend on market value --> capital structure may fluctuate

Costs of Financial Distress

The direct costs of financial distress include the legal and administrative cash expenses associated with bankruptcy. The indirect costs include foregone investment opportunities, reputational risk, impaired ability to conduct business, and costs stemming from conflicts of interest between managers and debtholders.

MM Proposition I (with taxes)

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. Market value of levered firm = market value of unlevered firm + tax shield

MM Proposition I (no taxes)

The value of the levered firm is the same as the value of the unlevered firm WACC is the same regardless of capital structure

Static trade-off theory

VL = VU + tD - PV(financial distress) - Firm value initially increases and WCC decreases with additional debt due to tax shield - Value starts decreasing when increase in expected value of financial distress outweighs tax benefits of debt

Value of firm with constant earnings (EBIT)

Value of leveraged firm = EBIT(1-t)/WACC (assuming cash flows are perpetual)