BUSINESS

FINANCE
FINS1613
Tutorial
Week12
Leverage&CapitalStructure

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 CONTACT DETAILS
YourTutor:
PeterAndersen
peter.andersen@unsw.edu.au

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FINS1613 PeterKjeldAndersen(2012S2)
 CHAPTER 13: PROBLEM 1
EBIT & LEVERAGE
BushrangerBuildingLtd(BBL)hasnodebtoutstandingandatotalmarket
valueof$70000.
Earningsbeforeinterestandtaxes,EBIT,areprojectedtobe$6000if
economicconditionsarenormal.
Ifthereisstrongexpansionintheeconomy,thenEBITwillbe25%higher.
Ifthereisarecession,thenEBITwillbe40%lower.
BBLisconsideringa$35000debtissuewitha6%interestrate.Theproceeds
willbeusedtorepurchaseordinaryshares.Therearecurrently3500
ordinarysharesoutstanding.Ignoretaxesforthisproblem.
Q. Calculateearningspershare,EPS,undereachofthethreeeconomic
scenariosbeforeanydebtisissued.Also,calculatethepercentagechanges
inEPSwhentheeconomyexpandsorentersarecession.
Q. RepeatPartA,assumingthatBBLgoesthroughwithrecapitalisation.What
doyouobserve?
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FINS1613 PeterKjeldAndersen(2012S2)
 CHAPTER 13: PROBLEM 1
EBIT & LEVERAGE
Q. Calculateearningspershare,EPS,undereachofthethreeeconomic
scenariosbeforeanydebtisissued.Also,calculatethepercentagechanges
inEPSwhentheeconomyexpandsorentersarecession.
A. RECESSION NORMAL EXPANSION
EBIT $3,600 $6,000 $7,500
Less: Interest
=EBT $3,600 $6,000 $7,500
Less:Taxes(@ 0%)
=Net Income $3,600 $6,000 $7,500
Divide:#sharesoutstanding 3,500 3,500 3,500
=EarningsPerShare $1.03 $1.71 $2.14
%changeinEPSfromNormal 40% 0% +25%

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FINS1613 PeterKjeldAndersen(2012S2)
 CHAPTER 13: PROBLEM 1
EBIT & LEVERAGE
Q. RepeatPartA,assumingthatBBLgoesthroughwithrecapitalisation.What
doyouobserve?
A. Fourstepsfortheleveragedrecapitalization:
I. Calculatethepricepershareatthemoment
$70,000
Current Price per share Market Value of Equity $20 / share
old # shares outstanding 3,500

II. Workouthowmanyofthosesharesyoucanpurchasewiththemoneyyouve
borrowedandhowmanyareleftafter
Money Spent $35,000
Shares Repurchased 1,750 shares repurchased
Current Price per share $20/share

New # shares oustanding Old # Shares Outsanding Shares Repurchased 3,500 1, 750 1, 750 shares outstanding

III. Workouthowmuchinterestyouwillhavetopayonthemoneyyouve
borrowed.
Interest Expense Amount Borrowed Interest Rate $35, 000 6% $2,100

IV. RecalculatetheEPSundereacheconomicscenario. 5
FINS1613 PeterKjeldAndersen(2012S2)
 CHAPTER 13: PROBLEM 1
EBIT & LEVERAGE
Q. RepeatPartA,assumingthatBBLgoesthroughwithrecapitalisation.What
doyouobserve?
A. RECESSION NORMAL EXPANSION
EBIT $3,600 $6,000 $7,500
Less: Interest (2,100) (2,100) (2,100)
=EBT $1,500 $3,900 $5,400
Less:Taxes(@ 0%)
=Net Income(postrecap) $1,500 $3,900 $5,400
Divide:#shares(postrecap) 1,750 1,750 1,750
=EarningsPerShare(postrecap) $0.86 $2.23 $3.09
%changeinEPSfromNormal 62% 0% +38%
Twothingsweobserveafteraddingleveragetoourcapitalstructure:
1.TheexpectedEPSundernormalconditionshasrisenfrom$1.71to$2.23
2.ThevolatilityintheEPSisnowgreaterthanthevolatilityintheEBIT
(i.e.thegoodtimesarebetterforequity,andthebadtimesareworse) 6
FINS1613 PeterKjeldAndersen(2012S2)
 CHAPTER 13: PROBLEM 3
ROE & LEVERAGE
SupposeourcompanyfromProblem1,BushrangerBuildingLtd,hasa
markettobookratioof1.0.
Q. Calculatereturnonequity,ROE,undereachofthethreeeconomicscenarios
beforeanydebtisissued.Also,calculatethepercentagechangesinROEfor
economicexpansionandrecession,assumingnotaxes.
Q. RepeatpartA,assumingthefirmgoesthroughwiththeproposed
recapitalisation.
Q. RepeatpartsAandBofthisproblem,assumingthefirmhasataxrateof
30%.
Net Income Market Value Equity
ROE Market-to-Book
Book Value Equity Book Value Equity
Asourcompanyhasamarkettobookof1.0,thisjustimplies
thatwecanusetheMarketValueof$70,000fromProb 1asits
BookValuetoworkoutROE
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FINS1613 PeterKjeldAndersen(2012S2)
 CHAPTER 13: PROBLEM 3
ROE & LEVERAGE
Q. Calculatereturnonequity,ROE,undereachofthethreeeconomicscenarios
beforeanydebtisissued.
RECESSION NORMAL EXPANSION
Net Income $3,600 $6,000 $7,500
Book Value(prerecap) $70,000 $70,000 $70,000
Return onEquity(ROE) 5.14% 8.57% 10.71%
%ChangeinROEfromnormal 40% 0% +25%
Q. Repeattheabove,assumingthefirmgoesthroughwiththeproposed
recapitalisation.
RECESSION NORMAL EXPANSION
Net Income(postrecap) $1,500 $3,900 $5,400
Book Value(postrecap) $35,000 $35,000 $35,000
Return onEquity(ROE) 4.29% 11.14% 15.43%
%ChangeinROEfromnormal 62% 0% +38% 8
FINS1613 PeterKjeldAndersen(2012S2)
 CHAPTER 13: PROBLEM 3
ROE & LEVERAGE
A. AdjustingtheROEforleverageasperthetableonthepreviousslidecould
alsobedoneusingthePropositionIIformulafromtheM&Mpaper.
RAisthereturnonthe
firmsassets,whichiswhat
itsRE wouldbewhenits RDisthefirmscostof
REisthereturn unlevered borrowing
onthefirms
equity D/E,thedebttoequityratioisthe
amountofdollarsofdebtper
D
RE RA RA RD dollarofequityinthefirmscapital
structure.DontconfusewithD/V
E whichisD/(D+E)

R E,recession R A,recession R A,recession R D

D 1
5.143% 5.143% 6% 4.29%
E 1

R A,normal R A,normal R D
D 1
R E,normal 8.571% 8.571% 6% 11.14%
E 1

R E,expansion R A,expansion R A,expansion R D

D 1
10.714% 10.714% 6% 15.43%
E 1
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FINS1613 PeterKjeldAndersen(2012S2)
 CHAPTER 13: PROBLEM 3
ROE & LEVERAGE
Q. RepeatpartsAandBofthisproblem,assumingthefirmhasataxrateof
30%.

RECESSION NORMAL EXPANSION

EBIT $3,600 $6,000 $7,500
Less: Interest (2,100) (2,100) (2,100)
=EBT $1,500 $3,900 $5,400
Less:Taxes(@ 30%) (450) (1,170) (1,620)
=Net Income(postrecap) $1,050 $2,730 $3,780
Book Value(postrecap) $35,000 $35,000 $35,000
Return onEquity(ROE) 3.00% 7.80% 10.80%
%ChangeinROEfromnormal 62% 0% 38%

NoticethatthepercentagechangeinROEisthesameasthepercentage
changeinEPS.ThepercentagechangeinROEisalsothesamewithorwithout
taxes. 10
FINS1613 PeterKjeldAndersen(2012S2)
 CHAPTER 13: PROBLEM 8
HOMEMADE LEVERAGE
Afirmisdebatingwhethertoconvertitsallequitycapitalstructuretoone
thatis25%debt.Currently,thereare5500sharesoutstandingandtheprice
pershareis$60.EBITisexpectedtoremainat$17,600peryearforever.The
interestrateonthenewdebtis8%andtherearenotaxes.
Q. Rick,ashareholderofthefirm,owns100shares.Whatishisexpectedcash
flowunderthecurrentcapitalstructure,assumingthefirmhasa100%
dividendpayoutratio?
Q. WhatwillRickscashflowsbeundertheproposedcapitalstructureofthe
newfirm?Assumehekeepsall100ofhisshares.
Q. Supposethefirmdoesconvert,butRickprefersthecurrentallequitycapital
structure.Showhowhecouldunlever hissharestorecreatetheoriginal
capitalstructure.
Q. Usingouranswerabove,explainwhythefirmschoiceofcapitalstructureis
irrelevant.
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FINS1613 PeterKjeldAndersen(2012S2)
 CHAPTER 13: PROBLEM 8
HOMEMADE LEVERAGE
Afirmisdebatingwhethertoconvertitsallequitycapitalstructuretoone
thatis25%debt.Currently,thereare5500sharesoutstandingandtheprice
pershareis$60.EBITisexpectedtoremainat$17,600peryearforever.The
interestrateonthenewdebtis8%andtherearenotaxes.
Q. Rick,ashareholderofthefirm,owns100shares.Whatishisexpectedcash
flowunderthecurrentcapitalstructure,assumingthefirmhasa100%
dividendpayoutratio?

EPSU
Net Income U EBIT Int 1 t
A.
# Shares Oustanding U # Shares Oustanding U

$17,600 $0 1 0 $3.20/share
5,500 shares
DPSU EPSU Payout Ratio $3.20 / share 100% $3.20 / share

Cash Flow to Rick DPSU # shares owned $3.20 / share 100 shares $320
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FINS1613 PeterKjeldAndersen(2012S2)
 CHAPTER 13: PROBLEM 8
Q. WhatwillRickscashflowsbeundertheproposedcapitalstructureofthe
newfirm?Assumehekeepsall100ofhisshares.
A. First,workoutthecurrentvalueofthefirmandcalculatetheamountofdebt
neededtorepurchase25%ofit.

MVEquity,U Share Price U # Shares Outstanding U $60 5,500 $330, 000

Debt Raised 25% MVEquity,U 25% $330, 000 $82,500

# Shares Outstanding L # Shares Outstanding U Shares Repurchased

Debt Raised
# Shares Outstanding U
Share Price U
$82,500
5,500 shares 4,125 shares remaining
$60/share 13
FINS1613 PeterKjeldAndersen(2012S2)
 CHAPTER 13: PROBLEM 8
A. Second,factorthenew(smaller)numberofsharesandtheinterestexpense
intoourEPSandDPS.
Int Debt Raised i D $82,500 8% $6, 600

Net IncomeL
DPSL 100% EPSL 100%
# Shares Oustanding L

100%
EBIT Int 1 t
# Shares Oustanding L

100%
$17,600 $6,600 1 0
$2.67/share
4,125 shares

Cash Flow to Rick DPSL # shares owned

$2.6667 / share 100 shares $266.67

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FINS1613 PeterKjeldAndersen(2012S2)
 CHAPTER 13: PROBLEM 8
Q. ShowhowRickcouldunlever hissharestorecreatetheoriginalcapital
structure.
A. Sincethefirmhasborrowedmoneyandwewishtoundothis,Rickneedsto
dotheopposite(i.e.lendmoney).
Rickwilldothisbysellingthesame%ofhissharesthatthefirmtookindebt.
Interest Income Money Lent i D 25% # Shares Owned Price 8%
25% 100 $60 8% $120
Cash Flow to Rick DPSL # remaining shares owned + Interest Income
$2.6667 / share 75 shares $120 $200 $120 $320

Q. Usingouranswerabove,explainwhythefirmschoiceofcapitalstructureis
irrelevant.
A. Thecapitalstructureisirrelevantbecauseshareholderscancreatetheirown
leverageorunlever thestocktocreatethepayofftheydesire,regardlessof
thecapitalstructurethefirmactuallychooses. 15
FINS1613 PeterKjeldAndersen(2012S2)
 M&M (1958)
Assumptions: VL

NoTaxes
Nobankruptcycosts+Noagencycosts
Informationisavailablefreelytoeveryoneinthemarket V U VL =VU

Individualsandcorporationsborrow/lendatthesamerates.
%Debt

Propositions:
1. VL =VU
Leveredfirmvalue(i.e.withdebt)=Unleveredfirmvalue(i.e.withoutdebt)
Capitalstructureisirrelevant.
2. RE =RA +(RA RD)(D/E)
Asyouincreasedebt,costofequitygoesupasriskincreases,butWACCremainsconstant.
WACCremainsconstantbecauseeventhoughdebtischeaperthanequity,theremainingequityinyour
capitalstructureincreasesinrisk,whichoffsetsthecheapnessofdebt.

SummaryofM&Mwithnotaxesorbankruptcycosts:
Choosewhatevercapitalstructureyouwant.Itwontaffectfirmvalue orWACC.
Increasingleveragewillincreasetheriskandcostofequity,however.
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FINS1613 PeterKjeldAndersen(2012S2)
 M&M (1958)
Inaworldwithnotaxes&nobankruptcycosts,CAPITALSTRUCTUREcanbesummarizedas:

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FINS1613 PeterKjeldAndersen(2012S2)
 CHAPTER 13: PROBLEM 12
WACC, COST OF EQUITY & NO TAXES
WanakaResortsLtdhasadebtequityratioof1.5.ItsWACCis10%,andits
costofdebtis7%.Thereisnocorporatetax.
Q. WhatisWanakascostofequitycapital?
Debt Debt 1.5
1.5 0.60 or 60%
Equity Debt Equity 1.5 1.0

E D Note:thereisno(1 taxc)onthecostofdebtas
WACC re rd wereassumingweliveinM&Msoriginalworld
V V
withnocorporatetaxes.
10% 0.40 re 0.60 7%
Also,notethatWACCwillremainsconstantat10%
irrespectiveofourlevelofdebt(becausecapital
re 14.50% structureisirrelevantunderM&Msoriginalpaper)

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FINS1613 PeterKjeldAndersen(2012S2)
 CHAPTER 13: PROBLEM 12
WACC, COST OF EQUITY & NO TAXES
CalculatingWACC.WanakaResortsLtdhasadebtequityratioof1.5.Its
WACCis10%,anditscostofdebtis7%.Thereisnocorporatetax.
Q. Whatwouldthecostofequitybeifthedebtequityratiowere2.0?Whatif
itwere0.5?Whatifitwerezero?
D D 2 1 2
2 WACC 10% r
3 e 3 7% re 16%
A. E V 2 1

D D 0.5 1.0 0.5

0.50 WACC 10% re 7% re 11.5%
E V 0.5 1 1.5 1.5

D D 0
0.00 WACC 10% 1.00 re 0.00 7% re 10%
E V 0 1
ThesequestionscouldhavealsobeenansweredusingthePropIIequation,
whichwouldhavesavedtheeffortconvertingfromD/EtoD/V:
D
RE RA RA RD
E 19
FINS1613 PeterKjeldAndersen(2012S2)
 M&M (1963)
Assumptions: VL
VL =VU +TcD
NoTaxes (thisassumptionwasrelaxed)
Nobankruptcycosts+Noagencycosts
Informationisavailablefreelytoeveryoneinthemarket V U VL =VU

Individualsandcorporationsborrow/lendatthesamerates.
%Debt
Propositions:
1. VL =VU+TcD
Leveredfirmvalue=Unleveredfirmvalue+PresentValueofInterestTaxShields.
2. RE =RA +(RA RD)(D/E)(1 Tc)
Asyouincreasedebt,costofequitystillgoesupasriskincreases.
But,becauseoftheinteresttaxshield,debtisevenmorecheaperrelativetoequitythanbefore.
Sotherefore,WACCdecreasesasyouincreasetheamountofdebtinyourcapitalstructure.
3. Projectsshouldbeevaluatedasthoughthefirmwas100%equity,withaseparateadjustment
madeforthefundingoftheproject.

SummaryofM&Mwithtaxes(butstillnobankruptcycosts):
Choose100%debtfinancingtoMAXIMIZEfirmvalueandMINIMIZEWACC.
Increasingleveragestillincreasescostofequity.
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FINS1613 PeterKjeldAndersen(2012S2)
 CHAPTER 13: PROBLEM 10
Q. GildedcageLtdusesnodebt.TheWACCis12%.Thecurrentmarketvalueof
thecompanyis$40million.Thecorporatetaxrateis40%.Whatisthevalue
ofthecompanyifGildedcageconvertstoadebttoequityratioof1?What
ifthedebttoequityratiois2?
A. TheD/Eratioof1implies$1ofdebtforevery$1ofequityoraD/Vratioof
50%.Thisis50%ofthevalueofthetotalfirmwhenlevered(VL).

VL VU Tc D VL VU Tc 0.5 VL VL $40m 0.4 0.5 VL

$40m
VL $40m 0.2VL VL $50m
0.8

Note:ThetextbooksolutionsforProblem10areincorrect.Themethod
showninthesolutionsforProblem19(asIvedoneabove)shouldbeused.
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FINS1613 PeterKjeldAndersen(2012S2)
 CHAPTER 13: PROBLEM 10
Q. GildedcageLtdusesnodebt.TheWACCis12%.Thecurrentmarketvalueof
thecompanyis$40million.Thecorporatetaxrateis40%.Whatisthevalue
ofthecompanyifGildedcageconvertstoadebttoequityratioof1?What
ifthedebttoequityratiois2?
A. TheD/Eratioof2implies$2ofdebtforevery$1ofequityoraD/Vratioof
66.67%.Thisis66.67%ofthevalueofthetotalfirmwhenlevered(VL).

VL VU Tc D VL VU Tc 0.6667 VL VL $40m 0.4 0.6667 VL

$40m
VL $40m 0.2667VL VL $54.55m
0.7333

Note:ThetextbooksolutionsforProblem10areincorrect.Themethod
showninthesolutionsforProblem19(asIvedoneabove)shouldbeused.
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FINS1613 PeterKjeldAndersen(2012S2)
 CHAPTER 13: PROBLEM 19
Q. GreenieCleaningexpectsanEBITof$35,000everyyearforever.Greenie
currentlyhasnodebtandtiscostofequityis14%.Thefirmcanborrowat
8%.Ifthecorporatetaxrateis30%,whatisthevalueofthefirm?Whatwill
thevaluebeiftheyconvertto50%debt,75%debtor100%debt?Whatdoes
thistellyouabouttherelationshipbetweentheD/Eratioandthetaxshield.
A. First,findtheunleveredvalueofthefirm(Vu).Werenottoldanythingabout
capitalexpenditure,depreciationorworkingcapital,soweassumethat
EBIT(1Tc)representsitsFreeCashFlow.
EBIT 1 Tc $35, 000 1 0.30
VU $175, 000
RU 0.14
Second,weleverthefirmto50%debtasperProblem10.
VL VU Tc D VL VU Tc 0.5 VL VL $175k 0.3 0.5 VL

$175k
VL $175k 0.15VL VL $205,882.35
0.85
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FINS1613 PeterKjeldAndersen(2012S2)
 CHAPTER 13: PROBLEM 19
A. Redothecalculationwith75%debt.

VL VU Tc D VL VU Tc 0.75 VL VL $175k 0.3 0.75 VL

$175k
VL $175k 0.225VL VL $225,806.45
0.775

Andwith100%debt
VL VU Tc D VL VU Tc 1.00 VL VL $175k 0.3 1.00 VL

$175k
VL $175k 0.30VL VL $250,000
0.70

Asthedebtequityratioincreases,M&MPropositionIshowsthatthevalueof
thefirmincreases.

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FINS1613 PeterKjeldAndersen(2012S2)
 (STATIC) TRADE OFF THEORY
AnotherRelaxedAssumption VL
VL =VU +TcD
Bankruptcycostsnowexist
DirectcostsarecoststhatareonlyincurredINbankruptcy VL =VU +TcD PVBC

E.g.Legal,administrator,andliquidationcosts
VU VL =VU
Indirectcosts areincurredbeforebankruptcyitself
e.g.Lostsalesfromcustomersworriedaboutlackofwarranty/repairs/etc.
%Debt
e.g.Suppliersnotprovidingthecompanywithtradecredit

Implication:
1. VL =VU+TcD PVBC
Leveredfirmvalue=Unleveredfirmvalue+PVofInterestTaxShields PVofBankruptcyCosts
Asdebtincreasesrelativetoequity,sodoestheprobabilityofacompanygoingbankrupt.

Summary(M&Mwithtaxesandbankruptcycosts):
At100%debtfinancing,thepresentvalueofthebankruptcycostswillbegreaterthan
thepresentvalueoftheinteresttaxshields.
Sotheoptimallevelofdebtfinancingwillbesomewherelessthan100%.
Thiswillbeatthepointwheretheadditionaldollarofdebtyourcompanytakesonis
offsetbyanadditionaldollarofbankruptcycosts(inpresentvalueterms).
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FINS1613 PeterKjeldAndersen(2012S2)
 AGENCY COST THEORY
Anotherrelaxedassumptionisthatagencycostsnowexist
Implication:
1. VL =VU+TcD PVBC+PVAC,e PVAC,d

Whatareagencyproblems?
Theyarisebecauseshareholdersandthemanagerswhoactoftheirbehalfmayhavedifferentobjectives.
Managersmaybetemptedtowastethecompanysexcesscash(freecashflow)onnegativeNPVinvestments
andonperquisiteconsumption
read:corporatejets,holidays,goldplatedbathrooms,Oktoberfesttickets

Howcantheagencyproblemsoftoomuchfreecashflowbelimited?
Throughusingtheexcesscashtoincreasedividends,repurchaseshares,doingaleveragedbuyout(LBO),or
increasingdebtfinancing.

Also,howcanincreasingdebtfinancingreduceagencycosts?
Itforcesfirmstopayoutcash,whichaddsvaluebypreventingunprofitablewastefulinvestments.
Italsoreducestheabilityofmanagerstowastefreecashflowonperquisiteconsumption.

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FINS1613 PeterKjeldAndersen(2012S2)
 SIGNALLING THEORY
AnotherRelaxedAssumption
EveryonedoesNOThaveequalaccesstothesameinformationaboutthecompanys
future(i.e.thereisinformationasymmetry)
Implication:
1. Ifacompanyhasgoodprosects,theywilloftenborrow,astheyaremoreconfidentin
beingabletopayoffthedebtwithoutgoingbankrupt.
Iftheyissuedmoreequityhowever,theoriginalequityholdersshareofthegoodfutureprospectswould
bedilutedamongstalargernumberofinvestors.
2. Butifthecompanyhaspoorfutureprospects,theyarelikelytoissueequity,asthere
isnoobligationtopaydividendsiftheycantaffordto(unlikeinterestpayments).
Also,managerswillissueequitywhenitisovervalued,soasnottodilutetheoriginalequityholders.

Summary:
Issuingdebtsendsapositivesignaltothemarketthatthemanagersareconfident
aboutthefirmsfutureprospects.
Andissuingequitysendsanegativesignal.

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FINS1613 PeterKjeldAndersen(2012S2)
 PECKING ORDER THEORY
ThisflowsonfromSignallingTheory

Twokeyassumptions:
1. Thereisasymmetricinformation(betweenmanagers/shareholders)
2. Managersactinthebestinterestofshareholders(i.e.equity)

Summary:
Managerswillseektouseinternalfinance(cashholdings,etc)overexternalfinance,so
asnottosendanyadverseexternalsignals
Nexttheywillchoosetousedebtasitsendsapositivesignal
Thenhybridsecurities
Thenlastlyequity,whichwouldsendanegativesignal.

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FINS1613 PeterKjeldAndersen(2012S2)
 CAPITAL STRUCTURE: MCQ 1
Thecorporatetaxrateis37%.TheMaPol Companyhasa$100milliondebt
outstandingwithacouponrateof7%perannum.Facevalueofeachbondis
$10,000andinvestorsrequirea7%returnondebtwithsimilarcreditrating.What
isthepresentvalueofthetaxshield?
a) $6,840,000
b) $25,300,800
c) $37,000,000
d) $30,160,000
e) $7,000,000
ANSWERISC
Tc i D D
PV of Tax Shield 0 Tc D 37% $100m $37m
iD
Becausethetaxessavedfromtheinterestrepayments(Int ExpensexTaxRateor
DxiD xTaxRate)aresavedeachyearinperpetuity,wecandiscountthesavings
bydividingbythecostofdebt(iD).Thecostofdebtcancelsoutonthenumerator
anddenominator,leavingyouwithTc xD. 29
FINS1613 PeterKjeldAndersen(2012S2)
 CAPITAL STRUCTURE: MCQ 2
Whichstatement/srelatedtoCapitalStructureTheoryis/arecorrect?
I. M&MPropositionIwithoutbothtaxandbankruptcysaysthatVL=VU
II. M&MPropositionIIwithoutbothtaxandbankruptcysaysthatthecostof
equityoftheleveredfirmisequaltothecostofequityofanunleveredfirm
III. M&MPropositionIIwithoutbothtaxandbankruptcysaysthattheoverallcost
ofcapitaloftheleveredfirmisequaltothecostofcapitalofanunleveredfirm
IV. M&MPropositionIwithtaxesonlysaysthatthevalueofthefirmincreasesin
financialleverage
a. I,II,IIIandIVarecorrect.
b. IIandIVonlyarecorrect.
c. IandIVonlyarecorrect
d. IandIIIonlyarecorrect.
e. I,IIIandIVonlyarecorrect.

AnswerEiscorrect.
StatementIIisincorrectbecausecostofequitywillincreaseinfirmsfinancialleverage.
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FINS1613 PeterKjeldAndersen(2012S2)
 CAPITAL STRUCTURE: MCQ 3
SupposeyouaretheCEOofapubliclytradedcompany.Ifyouknowthatyourfirm
isfacingrelativelypoorprospectsbutneedsnewexternalcapital,andyouknow
thatinvestorsdonothavethisinformation,signallinghypothesiswouldpredictthat
youwould:
a) Issueequitytosharetheburdenofdecreasedequityreturnsbetweentheold
andnewshareholders.
b) Postponegoingintocapitalmarketsuntilyourfirmsprospectsimprove.
c) Conveyyourinsiderinformationtoinvestorsusingthemediatoeliminatethe
informationasymmetry.
d) Issuedebttomaintainthereturnsofequityholders.
e) Beindifferentbetweenissuingdebtandequity.

ANSWERISA

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FINS1613 PeterKjeldAndersen(2012S2)
 EXTRA MCQ #1
Whichofthefollowingstatementsaboutcapitalstructuretheoryismostcorrect?
A. Signallingtheorysuggestsfirmsshouldatnormaltimesmaintainreserve
borrowingcapacitythatcanbeusedifanespeciallygoodinvestment
opportunitycomesalong.
B. Ingeneral,anincreaseinthecorporatetaxratewouldcausefirmstouseless
debtintheircapitalstructures.
C. Accordingtothestatictradeofftheory,anincreaseinthecostsofbankruptcy
wouldleadfirmstoreducetheamountofdebtintheircapitalstructures.
D. Statementsaandcarecorrect.
E. Allthestatementsabovearecorrect.

ANSWERISD

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FINS1613 PeterKjeldAndersen(2012S2)
 EXTRA MCQ #2
Thestatic(tradeoff)theoryofcapitalstructurepredictsthat:
A. Unprofitablefirmsshouldborrowmorethanprofitableones.
B. Safefirmsshouldborrowmorethanriskyones.
C. Rapidlygrowingfirmsshouldborrowmorethanmaturefirms.
D. Increasingleverageincreasesfirmvalue.
E. Alloftheseanswers.

ANSWERISB

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FINS1613 PeterKjeldAndersen(2012S2)
 EXTRA MCQ #3
TheSignallingtheoryforcapitalstructureimpliesthat:
A. Acompanywithpoorfutureprospectsshouldraisefinancethroughequity
issues.
B. Afirmthatraisesdebtwilloftenexperienceadecreaseinshareprice.
C. Whenequityisissued,thedilutioneffectistheonlyreasonforanydropinthe
valueofshares.
D. Alloftheseanswers.
E. Noneoftheseanswers.

ANSWERISA

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FINS1613 PeterKjeldAndersen(2012S2)
THE END

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FINS1613 PeterKjeldAndersen(2012S2)