Question

Question 3 (15 marks)

Capital Structure Policy

Part A. Imagine a firm that is expected to produce a level stream of operating profits. As leverage is increased, what happens to:

(a) The ratio of the market value of the equity to income after interest if M&M propositions are right?

(b) The ratio of the market value of the firm to income before interest if M&M propositions are right?

Part B. Each of the following statements is false or at least misleading. Use M&M propositions to explain why in each case.

(a) “As the firm borrows more and debt becomes risky, both stockholders and bondholders demand higher rates of return. Thus by reducing the debt ratio we can reduce both the cost of debt and the cost of equity, making everybody better off.”

(b) “Moderate borrowing doesn't significantly affect the probability of financial distress or bankruptcy. Consequently, moderate borrowing won't increase the expected rate of return demanded by stockholders.”

(c) “The more debt the firm issues, the higher the interest rate it must pay. That is one important reason why firms should operate at conservative debt levels.”

Answer 1

Answer :

part A :

(a)

As leverage is increased, the cost of equity capital rises. This is the same as saying that, as leverage is increased, the ratio of the income after interest (which is the cash flow stockholders are entitled to) to the value of equity increases. Thus, as leverage increases, the ratio of the market value of the equity to income after interest decreases.

(b)

(i)

Assume MM are correct. The market value of the firm is determined by the income of the firm, not how it is divided among the firm’s security holders. Also, the firm’s income before interest is independent of the firm’s financing. Thus, both the value of the firm and the value of the firm’s income before interest remain constant as leverage is increased. Hence, the ratio is a constant.

(ii)

Assume the traditionalists are correct. The firm’s income before interest is independent of leverage. As leverage increases, the firm’s cost of capital first decreases and then increases; as a result, the market value of the firm first increases and then decreases. Thus, the ratio of the market value of the firm to firm income before interest first increases and then decreases, as leverage increases

​​​​​​part B :

(a)

If the opportunity were the firm’s only asset, this would be a good deal. Stockholders would put up no money and, therefore, would have nothing to lose. However, rational lenders will not advance 100 percent of the asset’s value for an 8 percent promised return unless other assets are put up as collateral. Sometimes firms find it convenient to borrow all the cash required for a particular investment. Such investments do not support all of the additional debt; lenders are protected by the firm’s other assets too. In any case, if firm value is independent of leverage, then any asset’s contribution to firm value must be independent of how it is financed. Note also that the statement ignores the effect on the stockholders of an increase in financial leverage.

(b)

This is not an important reason for conservative debt levels. So long as MM’s Proposition I holds, the company’s overall cost of capital is unchanged despite increasing interest rates paid as the firm borrows more. (However, the increasing interest rates may signal an increasing probability of financial distress—and that can be important.

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