Capital Structure and WACC Principles
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Questions and Answers

Which of the following is true regarding the relationship between debt, equity, and the cost of capital (WACC)?

  • As the company increases its debt financing, the cost of equity decreases linearly, while the cost of debt remains constant.
  • As the company increases its debt financing, the cost of equity remains constant, while the cost of debt increases linearly.
  • As the company increases its debt financing, the cost of equity increases linearly, while the cost of debt remains constant. (correct)
  • As the company increases its debt financing, the cost of equity remains constant, while the cost of debt decreases linearly.

    • What is the primary goal of the capital structure decision?

  • Minimize the cost of equity.
  • Maximize the value of the company. (correct)
  • Maximize the dividend payout ratio.
  • Minimize the cost of debt.

    • According to MM Proposition II without Taxes, which of the following statements is true regarding the cost of equity and the debt/equity ratio?

  • The cost of equity is inversely proportional to the debt/equity ratio.
  • The cost of equity is independent of the debt/equity ratio.
  • The cost of equity is directly proportional to the debt/equity ratio. (correct)
  • The cost of equity is exponentially related to the debt/equity ratio.

    • Why does the cost of equity increase when a company uses more debt financing according to MM Proposition II without Taxes?

    <p>Because debt financing increases the risk of bankruptcy, thereby making equity more risky. (B)</p> Signup and view all the answers

    Which of the following is NOT an assumption used in MM Proposition II without Taxes?

    <p>The company pays taxes. (C)</p> Signup and view all the answers

    What does Modigliani and Miller Proposition I without Taxes state?

    <p>The market value of a company is determined by its cash flows, not by its capital structure. (A), The market value of a company is not affected by the capital structure of the company. (B), The capital structure of a company is irrelevant to its market value. (C)</p> Signup and view all the answers

    What two factors determine the risk of equity of a company?

    <p>Business risk and financial risk (C)</p> Signup and view all the answers

    In the context of MM Proposition I without Taxes, what does VL represent?

    <p>Value of the company with debt financing (A)</p> Signup and view all the answers

    According to MM Proposition I without Taxes, what is the relationship between VL and VU?

    <p>VL is equal to VU (B)</p> Signup and view all the answers

    What does WACC stand for?

    <p>Weighted Average Cost of Capital (B)</p> Signup and view all the answers

    What is the implication of the statement 'WACC for a company is unaffected by its capital structure in the no-tax case'?

    <p>The cost of capital for a company is determined solely by its business risk. (A)</p> Signup and view all the answers

    How does business risk affect the cost of capital for a company?

    <p>Higher business risk leads to a higher cost of capital. (C)</p> Signup and view all the answers

    Which of the following assumptions is NOT made in the Modigliani-Miller proposition with no taxes?

    <p>The company's operating income is affected by the changes in its capital structure. (A)</p> Signup and view all the answers

    What is the relationship between the cost of equity (re) and the debt-equity ratio, according to the Modigliani-Miller proposition with no taxes?

    <p>The cost of equity is an increasing function of the debt-equity ratio. (D)</p> Signup and view all the answers

    According to the Modigliani-Miller proposition with no taxes, what happens to the value of the company (VL) as the debt-equity ratio increases?

    <p>VL remains the same. (B)</p> Signup and view all the answers

    What is the relationship between the cost of debt (rd) and the debt-equity ratio, according to the Modigliani-Miller proposition with no taxes?

    <p>The cost of debt is a decreasing function of the debt-equity ratio. (A)</p> Signup and view all the answers

    What is the relationship between the weighted average cost of capital (WACC) and the debt-equity ratio, according to the Modigliani-Miller proposition with no taxes?

    <p>The WACC remains constant as the debt-equity ratio increases. (B)</p> Signup and view all the answers

    Which of the following is NOT a factor that can affect the value of the company according to the Modigliani-Miller proposition with no taxes?

    <p>The company's tax rate. (A)</p> Signup and view all the answers

    What is the difference between VL and VU in the Modigliani-Miller proposition with no taxes?

    <p>VL and VU are the same in the Modigliani-Miller proposition with no taxes. (D)</p> Signup and view all the answers

    According to the Modigliani-Miller proposition with no taxes, what can a company do to increase its value?

    <p>Invest in profitable projects. (C)</p> Signup and view all the answers

    Flashcards

    Capital Structure

    The mix of debt and equity used to finance a business.

    WACC

    Weighted Average Cost of Capital; the average cost of capital from all sources.

    Cost of Equity

    The return required by equity investors, which increases with more debt.

    MM Proposition II

    States that the cost of equity is a linear function of the debt/equity ratio.

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    Debt vs. Equity

    Debt has a prior claim on assets; cost of debt is generally less than cost of equity.

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    Market Value of Company

    The total market value of a company's equity and debt.

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    Risk of Equity

    The market value of equity divided by the total value of the company.

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    Total Value of Company (V)

    The total market value represented as V = D + E (debt + equity).

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    Business Risk

    Risk associated with the company's operations that affects its cash flows.

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    Financial Risk

    Risk that arises from the use of financial leverage in a company's capital structure.

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    Value of Levered Company (VL)

    The value of a company when debt is included; VL = VU in no-tax scenarios.

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    Marginal cost of debt

    The cost of borrowing one additional unit of debt, considering the impact of taxes.

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    Homogeneous expectations

    The assumption that all investors have the same expectations about future returns.

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    Perfect capital markets

    Markets where there are no transaction costs, taxes, and where all information is available to all market participants.

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    Risk-free rate

    The return on an investment with no risk of financial loss, often represented by government bonds.

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    Agency costs

    Costs incurred due to conflicts of interest between stakeholders, such as shareholders and management.

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    Operating income and capital structure

    The notion that changes in a company's capital structure do not affect its operating income.

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    Debt/equity ratio

    A measure of a company's financial leverage calculated by dividing its total liabilities by shareholder equity.

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    Study Notes

    Capital Structure

    • A capital structure is the mix of debt and equity used by a company to finance its operations.
    • The goal of capital structure decisions is maximizing company value and minimizing the weighted average cost of capital (WACC).

    Weighted Average Cost of Capital (WACC)

    • WACC is the overall average cost of raising capital for a company.
    • Formula: WACC = (Weight of Debt × Cost of Debt) + (Weight of Equity × Cost of Equity)
    • Cost of debt (ra) generally is lower than Cost of Equity (re).
    • ra represents the before-tax marginal cost of debt.
    • re represents the marginal cost of equity.
    • t is the marginal tax rate.
    • Total value of company = V = D + E
    • D = Market value of debt / value of company
    • E = Market value of equity / value of company

    Modigliani and Miller (MM) Propositions (No Taxes)

    • Proposition I: The market value of a company is not affected by its capital structure. Value of a levered company (VL) = Value of an unlevered company (VU)
    • Proposition II: The cost of equity is a linear function of the company's debt-to-equity ratio. As debt increases, cost of equity linearly increases, but WACC and cost of debt remain constant.

    MM Propositions (With Taxes)

    • Proposition I: The market value of a levered firm exceeds the market value of an unlevered firm by an amount equal to the present value of the tax shield from debt (t * D). VL = VU + tD
    • Proposition II: WACC is minimized when debt is maximized. Cost of equity rises with debt but not as steeply as in the no-tax case since interest payments on debt are tax deductible.

    Cost of Financial Distress

    • Cost of financial distress is the cost of uncertainty about a firm’s ability to meet its obligations arising from lower or negative earnings
    • It has direct and indirect components
    • Cost of distress is lower when assets have higher secondary market values
    • Cost of distress is higher when assets have fewer tangible assets like high-tech growth companies

    Practical Issues in Capital Structure Policy

    • Considering changes in a company's capital structure over time
    • Analyzing the capital structures of competitors with similar business risks.
    • Evaluating company-specific factors such as quality of corporate governance.
    • External factors like industry, volatility of cash flows, and financial flexibility are also important

    Practical Issues in International Capital Structure

    • Leverage depends on company-specific factors (i.e., probability of bankruptcy, profitability, quality/structure of assets, growth opportunities, and industry affiliations).
    • Institutional, legal, and financial market parameters, along with macroeconomic factors play major role in capital structure for companies across different countries.

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    Capital Structure PDF

    Description

    This quiz explores the concepts of capital structure and the weighted average cost of capital (WACC). Understand the impact of debt and equity on company value, as well as the Modigliani and Miller propositions. Test your knowledge on the fundamentals of financing and capital costs.

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