ACF - Capital Structure Case Study.

The Modigliani-Miller theorem in the absence of tax - correct answer A good starting point: When is leverage irrelevant? Start in a 'perfect' world No taxes No market frictions Perfect capital markets: Firms and investors can borrow/lend at the same rate Equal access to all relevant information No transaction costs Firms in distress can be reorganizes without cost Managers act in shareholders' interests MM Proposition I - correct answer MM I without taxes : the value of a firm is independent of its capital structure: VL=VU Implication: For financing decisions to matter, they must address some 'imperfections' not present in MM's world Example of imperfections: MM I with taxes Firm value increases with leverage due to tax shield: VL=VU+PV(Tax shield) Using M&M sensibly - correct answer M&M is not a literal statement about the real world It helps you think about the right question How is a particular financing decision going to change the size of the pie? What imperfection does this decision address? M&M exposes some fallacies such as: - correct answer WACC fallacy "Debt is better because debt is cheaper than equity" EPS fallacy "Debt is better because it makes EPS go up" Win-Win fallacy "Debt is better because some investors prefer debt to equity" The WACC fallacy - correct answer This reasoning ignores the "hidden" cost of debt: Raising more debt makes existing equity more risky (See MM Proposition II) This is unrelated to default risk and true when debt is risk-free Because debt is safer than equity, investors demand a lower return for holding debt than for holding equity - correct answer (True) So, companies should always finance themselves with debt because they have to give away less returns to investors, i.e., debt is cheaper - correct answer (False) The EPS fallacy - correct answer Confusion of expected returns and risk EBIT is unaffected by a change in capital structure Creditors receive the safe (or the safest) part of EBIT Expected EPS might increase but EPS has become riskier! Again, see MM II EPS can go up (or down) when a company increases its leverage - correct answer (True) Companies should choose their financial policy to maximize their EPS - correct answer (False) The Win-Win fallacy - correct answer Investors can borrow/lend on their own account Investors who like leverage can create "home-made leverage" by borrowing Investors who dislike leverage can "undo" corporate leverage by lending Investors differ in their preferences and needs, and thus want different cash flow streams - correct answer (True) Some investors like debt while others prefer equity Firm value increases if it issues different securities tailored for different clienteles of investors - correct answer (False) 3. Trade-off Theory of Capital Structure - correct answer Taxes: - correct answer In MM world with corporate tax, optimal capital structure consists of 100% debt But the benefit of tax shields may be limited: Some firms don't pay taxes Negative or low earnings Non-debt tax shields (depreciation, R&D expenses) Tax Loss Carry Forwards (TLCF) Higher TLCF means less debt is optimal Personal taxes If capital gains are taxed less than income, then equity dominates debt Limits to the use of debt - correct answer Most firms seem to avoid having large amount of debt What are the costs associated with debt?