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Questions and Answers
What is the term for the mixture of debt and equity in a firm's capital structure?
What is the term for the mixture of debt and equity in a firm's capital structure?
In a perfect capital market, what is one condition that is NOT typically assumed?
In a perfect capital market, what is one condition that is NOT typically assumed?
What fraction of a firm's total value corresponds to its debt?
What fraction of a firm's total value corresponds to its debt?
If a coffee shop has an expected cash flow of $34,500 in one year and a required return of 15%, what is the present value of this cash flow?
If a coffee shop has an expected cash flow of $34,500 in one year and a required return of 15%, what is the present value of this cash flow?
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How much equity can be raised if the cash flow after paying off debt is $18,750 and the equity cash flow discounted is $16,304?
How much equity can be raised if the cash flow after paying off debt is $18,750 and the equity cash flow discounted is $16,304?
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What effect does adding leverage have on a firm's cost of equity capital?
What effect does adding leverage have on a firm's cost of equity capital?
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What is the primary reason a firm may choose to incorporate debt into its capital structure?
What is the primary reason a firm may choose to incorporate debt into its capital structure?
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Which of the following would be an example of an assumption made in a perfect capital market regarding transaction costs?
Which of the following would be an example of an assumption made in a perfect capital market regarding transaction costs?
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What effect does corporate debt have on a corporation's taxes?
What effect does corporate debt have on a corporation's taxes?
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How is the Interest Tax Shield calculated?
How is the Interest Tax Shield calculated?
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What is the consequence of a company having higher interest expenses?
What is the consequence of a company having higher interest expenses?
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Given a corporate tax rate of 35% and $300 million in interest expenses, what is the Interest Tax Shield for Safeway, Inc.?
Given a corporate tax rate of 35% and $300 million in interest expenses, what is the Interest Tax Shield for Safeway, Inc.?
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What is the expected cash flow at the end of the year if demand is as expected?
What is the expected cash flow at the end of the year if demand is as expected?
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What amount will the firm owe debt holders at the end of the year after borrowing $50,000?
What amount will the firm owe debt holders at the end of the year after borrowing $50,000?
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If demand is weak, what will the equity holders receive?
If demand is weak, what will the equity holders receive?
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Calculating the expected return based on a payoff of $32,000 and an equity value of $25,000, what is the expected return?
Calculating the expected return based on a payoff of $32,000 and an equity value of $25,000, what is the expected return?
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What is the expected return for equity holders without debt, if the cash flow is $84,000?
What is the expected return for equity holders without debt, if the cash flow is $84,000?
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According to Modigliani and Miller, what impact does leverage have on the risk of equity?
According to Modigliani and Miller, what impact does leverage have on the risk of equity?
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If only $6,000 is borrowed to finance the coffee shop, how does the debt-equity ratio affect the cost of equity?
If only $6,000 is borrowed to finance the coffee shop, how does the debt-equity ratio affect the cost of equity?
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What should the value of the firm's equity be when borrowing $50,000?
What should the value of the firm's equity be when borrowing $50,000?
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In a levered firm, how are cash flows divided?
In a levered firm, how are cash flows divided?
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According to MM Proposition I, what remains unchanged by a firm's capital structure?
According to MM Proposition I, what remains unchanged by a firm's capital structure?
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If a firm has total cash flows of $30,000 and borrows $6,000, what will the equity value be?
If a firm has total cash flows of $30,000 and borrows $6,000, what will the equity value be?
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What does borrowing increase regarding firm equity?
What does borrowing increase regarding firm equity?
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If a firm owes its debt holders $6,300 and total cash flows are $34,500, what is the expected payoff to equity holders?
If a firm owes its debt holders $6,300 and total cash flows are $34,500, what is the expected payoff to equity holders?
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What is the expected return of equity when borrowing $6,000, with an equity value of $24,000 and cash flows to equity of $28,200?
What is the expected return of equity when borrowing $6,000, with an equity value of $24,000 and cash flows to equity of $28,200?
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In a scenario with weak demand, if the equity holders receive $20,700, what is their return based on an equity value of $24,000?
In a scenario with weak demand, if the equity holders receive $20,700, what is their return based on an equity value of $24,000?
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What should the total cash flows to a firm be if it is valued at $75,000 after borrowing $50,000?
What should the total cash flows to a firm be if it is valued at $75,000 after borrowing $50,000?
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What is one consequence creditors may face during bankruptcy?
What is one consequence creditors may face during bankruptcy?
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What does the Tradeoff Theory suggest about the total value of a levered firm?
What does the Tradeoff Theory suggest about the total value of a levered firm?
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How does an increase in a firm's liabilities affect its probability of financial distress?
How does an increase in a firm's liabilities affect its probability of financial distress?
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What is the optimal level of debt, D*, determined by?
What is the optimal level of debt, D*, determined by?
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What can explain why firms might choose lower levels of debt than optimal?
What can explain why firms might choose lower levels of debt than optimal?
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What is meant by agency costs in the context of capital structure?
What is meant by agency costs in the context of capital structure?
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How does debt influence the behavior of managers in a firm?
How does debt influence the behavior of managers in a firm?
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Which factor does NOT contribute to financial distress costs?
Which factor does NOT contribute to financial distress costs?
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What is the primary focus of the pecking order hypothesis?
What is the primary focus of the pecking order hypothesis?
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Which of the following is a consequence of high leverage regarding agency costs?
Which of the following is a consequence of high leverage regarding agency costs?
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What benefit does the interest tax shield provide to firms?
What benefit does the interest tax shield provide to firms?
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Which factor is NOT a determinant of capital structure?
Which factor is NOT a determinant of capital structure?
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When should a firm consider changing its capital structure?
When should a firm consider changing its capital structure?
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What is a key strategy to signal confidence in a firm's ability to meet its debt obligations?
What is a key strategy to signal confidence in a firm's ability to meet its debt obligations?
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What does the conflict of interest between equity and debt holders primarily arise from?
What does the conflict of interest between equity and debt holders primarily arise from?
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Which type of financing do managers prefer as the last option according to the pecking order theory?
Which type of financing do managers prefer as the last option according to the pecking order theory?
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Study Notes
Capital Structure
- Capital structure is the collection of securities a firm issues to raise capital from investors.
- A mixture of debt and equity.
- Financial leverage is the blend of debt and equity.
- A firm's debt-to-value ratio is the fraction of the firm's total value that corresponds to debt (V = D / (E +D)).
- Capital structure choices vary across industries and within industries due to many factors impacting the choice.
Debt-to-Equity Ratio
- The average debt-to-equity ratio of non-financial corporations varied yearly from 0.51 to 0.64.
- The ratios for different companies (e.g., Asahi India Glass) were reported for multiple financial years (FYs).
Factors Affecting Capital Structure Choices
- The user is asked for factors affecting a company's capital structure (CS) choices.
Capital Structure in Perfect Capital Markets
- A perfect capital market is a market where securities are fairly priced, there are no tax consequences or transaction costs, and investment cash flows are independent of financing choices.
- Modigliani and Miller (MM) theory states that in a perfect capital market, the total value of a firm is equal to the market value of the firm's free cash flows and isn't affected by the choice of capital structure.
- Unlevered firm cash flows to equity equal the free cash flows from the firm's assets.
- In a levered firm, cash flows are divided between debt and equity holders and the total cash flow to all investors equals the free cash flows generated by the firm's assets.
- Application : A coffee shop example with $24,000 initial cost and $34,500 expected cash flow (in one year), and a 15% risk rate.
Equity Financing
- Equity financing, or unlevered financing, involves raising capital solely by selling equity to family and friends.
- A coffee shop example with $24,000 initial cost, $34,500 expected cash flow (in one year) and 15% risk rate. Calculations were provided to obtain the Net Present Value (NPV) of $6,000 and the value to the owner of $6,000 (in one year).
Levered Financing (Debt + Equity)
- Levered financing is financing a project using both debt and equity.
- A coffee shop example with $15,000 in debt and a 5% risk-free rate. Calculations were shown to arrive at equity value ($16,304) and additional value from leverage ($1,304).
- The example indicates leveraging a project can increase its value and the effect of leverage impacting risk.
The Risk and Return of Levered Equity
- Analysis of a coffee shop and borrowing only $6,000 for financing.
- Calculations showed the firm's total cash flows are unchanged (still $30,000)
- The equity will be worth $24,000 after accounting for the debt
- The expected return was calculated at 17.5% under different scenarios.
- Firm's equity is more risky when there is debt than without debt. (However, less risky than if borrowing $15,000).
Class Exercise - 1
- A coffee shop example with $50,000 borrowed to finance a shop valued at $75,000, with variable demand conditions (weak, expected, and strong).
- Calculations were shown to determine the value of the equity and expected return.
- Differences in the scenarios (demand) resulted in different return expectations.
Debt and Taxes
- Corporate taxes create a role for capital structures because interest expenses can be deducted which lowers taxes and increases the amount available to pay investors, increasing the corporation value.
- Example: Safeway, Inc., in 2012, had earnings before interests and taxes ($1.13 billion), interest expenses ($300 million), and a corporate tax rate of 35%.
- Calculations were provided to compare Safeway's actual net income with what it would have been without debt.
Interest Tax Shield
- The gain to investors from the tax deductibility of interest payments. Calculation formula was provided
- Example: An E.C. Builders/ECB income statement was presented, to calculate the interest tax shield. Calculations were performed over years 2010 through 2013.
Optimal Capital Structure: Tradeoff Theory
- The total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt less any present value of financial distress costs.
- Key qualitative factors in the present value of financial distress costs determination: probability of financial distress, likelihood a firm will default, the amount of liabilities compared to assets, and the volatility of cash flows and asset values.
- Debt level that maximizes the value of the levered firm.
- Debt will be lower for firms with higher cost of financial distress.
Additional Consequences of Leverage: Agency Costs and Information
- Conflicts of interest between stakeholders.
- Manager decisions that may benefit themselves at investor expense (reduce their effort, spend excessively on perks, engage in 'empire building').
- Debt provides incentives in running firms efficiently.
- The increased presence of monitoring to manage may reduce the funds available to use wastefully.
Pecking Order Theory
- Managers' preference for funding investments using retained earnings, followed by debt, and finally equity.
Capital Structure: Putting it Together
- Use the interest tax shield if the firm has consistent income
- Balance tax benefits of debt against costs of financial distress.
- Consider short-term debt for external financing where agency costs are significant
- Increase leverage to demonstrate confidence in the firm's ability to meet its debt obligations.
Determinants of CS - Factors
- Profitability, growth, cash flow, size of firm, industry characteristics, interest rates, tax structure, and assets tangibility.
Rising Burden of Debt in Indian Cos.
- Graph showing total debt (in trillions) and year-on-year percentage changes of debt from FY11 to FY23 in India.
Industry Trend last two years
- Data on sector share of different industry sectors and their debt-to-equity ratios in 2022-23.
Does Size Matters?
- Data table showing aggregate debt-to-equity ratio in times of large, medium, and small companies over financial years 2019 -2023.
Profitability Data
- Summary of profitability data, for the 12-year period, for the sample company. Data include total income, operating profits, and net profits are provided.
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Description
Test your knowledge on the fundamentals of capital structure and financing decisions within firms. This quiz covers concepts such as the mix of debt and equity, present value calculations, and the effects of leverage on costs. Dive in to assess your understanding of these essential financial principles!
