Question

1. What happens to the component costs of debt and equity when the debt ratio is increased? Why does this occur?

2. What does the MM theory with no taxes state about the value of a levered firm versus the value of an otherwise identical but unlevered firm? What does this imply about the optimal capital structure?

3. Why does the MM theory with corporate taxes lead to 100% debt?

4. What does the Miller model with personal and corporate taxes imply about value relative to the MM model with just corporate taxes?

5. What is the trade-off theory?

6. Explain how asymmetric information and signals affect capital structure decisions.

7. What is meant by reserve borrowing capacity, and why is it important to firms?

8. What is the pecking order hypothesis, and how does it influence firms’ capital structures?

9. How can the use of debt serve to discipline managers?

10. Which capital structure theories does the empirical evidence seem to support?

11. What issues should managers consider when making capital structure decisions?

12. Write out the Hamada equation.

13. What is the equation for calculating a firm’s unlevered beta?

14. Your firm’s CEO has just learned about options and how your firm’s equity can be viewed as an option. Why might he want to increase the riskiness of the firm, and why might the bondholders be unhappy about this?

15. What are some factors that financial managers consider when choosing the maturity structure of their debt?

Answer 1

Question 1: As the debt ratio is increased, the increased debt makes the additional more expensive which increases the cost of debt. Since investors see additional risk of financial distress with more debt, equity costs will also increase as investors will want higher returns for the higher risk.

Question 2: In the no tax theory, the MM proposition states that capital structure makes no difference between the firms. Hence an unlevered firm and a levered firm will have the same value. So, this implied that capital structure is irrelevant in valuing a firm. Hence there is no optimal capital structure.

Question 3: This is because as per MM theory with taxes, debt has a tax advantage and the value of the levered firm would increase with increase in debt. Hence a 100% debt company will have the highest value.

Question 4: Miller model sates that there are personal taxes and the interest payments that are made to investors would be treated as income in the hands of the investor. Hence there are two aspects, personal and corporate taxes. The firm gets a tax advantage on the interest payments and the investor who receives this income pays taxes on it. So basically everything becomes taxed in the end.

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