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LOS f: Discuss the Modigliani-Miller (MM) propositions concerning capital structure, including the impact of leverage, taxes, financial distress, agency costs, and asymmetric information on a company's cost of equity, cost of capital, and optimal capital structure.

Which of the following statements about a firm's capital structure is FALSE?

A)	The optimal capital structure is the one that minimizes the weighted average cost of capital and consequently maximizes the value of the firm's share price.

B)	If bankruptcy costs were included into the M&M analysis of capital structure in a tax world there would be an optimal capital structure between no debt and all debt.

C)	The firm's share price is maximized when the firm maximizes its earnings per share while it minimizes its cost of capital.

The optimal capital structure is the one that maximizes stock price and minimizes the WACC. The optimal capital structure is not the one that maximizes the firm’s EPS.

Which of the following statements about capital structure theories is most accurate?

A)	In a world with taxes and bankruptcy costs one would expect there to be an optimal capital structure where the cost of capital is minimized and share price is maximized.

B)	Based on signaling theory, if a firm issues new common stock it means that the firm thinks future investment prospects are better than normal.

C)	In a Modigliani and Miller (MM) world with taxes, but no bankruptcy cost, you would expect to see firms taking on very little debt.

The other statements are false. In a tax world without bankruptcy the optimal capital structure is 100% debt. When firms issue new equity investment projects look poor.

Modigliani and Miller demonstrated that if corporate taxes and bankruptcy costs are introduced into an otherwise perfect world the weighted average cost of capital (WACC) will:

A)	fall continuously as more debt is added to the capital structure.

B)	fall, then bottom out, and finally start to rise.

C)	rise, then plateau, and finally start to fall.

The WACC first falls because bondholders take less risk and, consequently, have a lower required rate of return. In addition, interest expenses are tax deductible. However, as the amount of debt rises, financial risk rises, and the chance for bankruptcy increases. If there are positive bankruptcy costs, both bondholders and stockholders will require increasingly higher rates of return as financial risk increases causing the WACC to rise. This rise offsets the benefits of using the cheaper source of financing.

Modigliani and Miller demonstrated that if corporate taxes are introduced into an otherwise perfect world, the optimal capital structure would be:

In this almost perfect world, the tax deductibility of interest payments encourages firms to use more debt in their capital structures. Since the more the firm borrows the greater the tax write-offs, the firm is encouraged to hold the maximum amount of debt possible. There could essentially be a single equity share, making up a very small portion of the financing, and the remainder, essentially 100%, would be financed with debt.

Bavarian Crème Pies (BCP) has been baking and selling cakes, pies, and other confectionary items for more than 150 years. The company started out, like many firms, as a small Mom and Pop operation. Today the firm has more than 4500 employees at 10 facilities in Germany, France, Belgium, and Holland. BCP’s stock has recently been under considerable pressure, and is trading at a 15-year low. The Bank of Munich, the firm’s primary lender and also a major stockholder, has succeeded in forcing BCP’s CEO into accepting an early retirement package.

The new CEO, Dietmar Schulz, is attempting to turn around the firm’s loss of market value, and reviving the attractiveness of the firm as an investment. BCP’s sales have been strong, growing by more than 5 percent during the past year to a new record. Firm profits, while not growing at the pace he believes that they can, remain positive, and measures of profitability remain within what he considers to be acceptable bounds. Therefore, he believes that the firm’s valuation problem may emanate from the choice of capital structure, which is currently 30 percent equity and 70 percent debt.

Because of their financial interest in the firm, the Bank of Munich has made it clear that they will provide whatever assistance they can to help the effort. Schulz has enlisted the services of one of the bank’s corporate finance team, Katarina Iben, CFA. Iben has advised other bank customers regarding capital structure, and has helped them to devise plans to improve shareholder value. Schulz has begun to prepare a list of topics that he wants to address with Iben when she meets with BCP’s finance staff on Friday.

On the top of the list of questions is the matter of whether or not the sources of a firm’s capital can affect firm value. Schulz recalls that during his days as a master’s degree student at the London School of Economics his professors told about the M and M theories regarding capital structure. As it has been some time since he has thought about these theories, he plans to ask Iben to discuss them with his staff.

Schulz also recalls that many theoretical concepts are based upon assumptions about markets and market frictions. He is concerned that, whatever the outcome of the finance staff’s discussions with Iben, any decisions made by BCP must remain grounded in the real world so that he can defend them to his board and to shareholders. To this end, he plans to foster a discussion with Iben and his staff concerning some of the practical matters that pertain to the firm’s capital structure in the real world.

Three days later Iben has arrived at BCP’s headquarters for the big meeting. Schulz opens the discussion by asking Iben to characterize the main objective concerning capital structure, and how one might go about assessing whether or not BCP was anywhere near meeting this objective.

Which of the following statements correctly characterizes the main objective of the capital structure decision?

A)	Firms have a preference ordering for capital sources, preferring internally-generated equity first, new debt capital second, and externally-sourced equity as a last resort.

B)	Increasing the use of relatively lower cost debt causes the required return on equity to increase such that the overall cost of capital is unchanged.

C)	Regardless of how the firm is financed, the overall value of the firm and aggregate value of the claims issued to finance it remain the same.

MM proposition 1 states that regardless of how the firm is financed, the overall value of the firm and aggregate value of the claims issued to finance it remain the same. (Study Session 8, LOS 29.h)

A)	Firms will seek to use debt financing up to the point that the value of the tax shield benefit is outweighed by the costs of financial distress.

B)	Regardless of how the firm is financed, the overall value of the firm and aggregate value of the claims issued to finance it remain the same.

C)	Increasing the use of relatively lower cost debt causes the required return on equity to increase such that the overall cost of capital is unchanged.

MM proposition 2 states that increasing the use of relatively lower cost debt causes the required return on equity to increase such that the overall cost of capital is unchanged. (Study Session 8, LOS 29.g)

Financial distress costs, agency costs, and the costs associated with asymmetric information are all factors that have the potential to influence capital structure. Homogeneous expectations is an assumption that underlies the MM capital structure propositions. (Study Session 8, LOS 29.g)

A)	there is no optimal capital structure.

B)	the value of the firm is not affected by the choice of capital structure.

C)	there is an optimal capital structure.

The main conclusion of the static trade-off theory is that there is an optimal capital structure, and that this is based upon the firm’s characteristics. Firms will seek to use debt financing up to the point that the value of the tax shield benefit is outweighed by the costs of financial distress. The value of the tax shield is a function of the firms’ tax rate, and the costs of financial distress are a function of the nature of the firm’s business. (Study Session 8, LOS 29.k)

A)	The quality of the firm’s corporate governance.

B)	Changes in the structure over time.

C)	The proximity of the current structure to the stated target.

Even if the current structure is consistent with the firm’s stated target capital structure, this does not ensure that it is value maximizing. The other items listed can provide useful information regarding whether the firm’s existing capital structure is optimal. (Study Session 8, LOS 29.o)

Frank Collins, CFA, is managing director for Brisbane Capital Resources, an Australian fund manager. The firm has had great success through the years with its growth-oriented investment strategy, but has suffered when the markets change in favor of value investment strategies. Consequently, Collins is exploring how the firm might increase its presence in the value sector of the market.

Many of the firms that reside in the value sector are those that have fallen on hard times, and have underperformed their peers. During his examination of firms meeting various value criteria, Collins has noted that while falling sales and the lack of profits are sometimes the obvious causes of the substandard performance, in other cases sales and profits do not appear to be the root cause. He wonders if the way that these firms have been capitalized is having a negative impact on their values.

Collins recalls from his days of studying finance at the University of Queensland, that a Nobel Prize was awarded for one of the theories in the capital structure area. His recollection of the details is sketchy, so he has contacted Dr. Martin Gray from UQ’s Department of Commerce to discuss capital structure in theory and in practice.

Gray tells Collins that his memory is indeed correct, that a Nobel Prize was awarded to Miller and Modigliani for their work in explaining the capital structure decision. Interestingly, he notes that their theories say that, under the right circumstances, capital structure is irrelevant. Obviously, the key is whether or not the right circumstances are relevant to what is observed in the real world.

Gray continues to tell Collins that there are a variety of matters that complicate the MM theory in practice. Firms pay taxes, managers may be motivated by their own self-interests, and adjustments to a firm’s capital structure are not costless. All of these factors affect the MM theories, and have given rise to other theories that attempt to explain why firms finance themselves as they do.

Collins also wonders if capital structure decisions are affected in any way by the country in which the firm is domiciled. He knows that Australia tends to follow the Anglo-American financial model, but that firms in continental Europe, Japan, and other countries are more accustomed to relying upon banks for capital. He wonders if this affects the capital structures observed across firms, even when the firms have the same underlying business risk.

Finally, Collins asks Gray about corporate debt ratings. Gray tells him that ratings fall broadly across two classes—investment grade and speculative—with a variety of ratings within each class. Moreover, Gray advises that firms usually seek to maintain a credit rating in the investment grade class, since some fiduciary investors are precluded from holding debt in the speculative class. Collins wonders if a firm’s debt ratings have any bearing upon the choice of capital structure.

Which of the following statements most accurately characterizes the static trade-off theory of capital structure?

A)	Firms will seek to use debt financing up to the point that the value of the tax shield benefit is outweighed by the costs of financial distress.

B)	Regardless of how the firm is financed, the overall value of the firm and aggregate value of the claims issued to finance it remain the same.

C)	Increasing the use of relatively lower cost debt causes the required return on equity to increase such that the overall cost of capital is unchanged.

The static trade-off theory of capital structure states that firms will seek to use debt financing up to the point that the value of the tax shield benefit is outweighed by the costs of financial distress. In other words, the capital structure is determined by the trade-off between these two factors. (Study Session 8, LOS 29.k)

A)	Regardless of how the firm is financed, the overall value of the firm and aggregate value of the claims issued to finance it remain the same.

B)	Firms will seek to use debt financing up to the point that the value of the tax shield benefit is outweighed by the costs of financial distress.

C)	Firms have a preference ordering for capital sources, preferring internally-generated equity first, new debt capital second, and externally-sourced equity as a last resort.

The pecking order theory of capital structure assumes that firms have a preference ordering for capital sources. They prefer to use internally-generated equity first. When the internally-generated equity is exhausted, they issue new debt capital. As a last resort they will rely on externally-sourced equity. The reason that new equity is the last resort is that the issuance of new stock is assumed to send a negative signal to investors regarding firm value. (Study Session 8, LOS 29.l)

A)	firms should increase the use of equity financing because of its inherent tax advantages.

B)	the firm derives a tax shield benefit from using debt because the interest expense is tax-deductible.

C)	the costs of financial distress become relevant to the analysis.

The main impact of incorporating corporate income taxes is that the firm derives a tax shield benefit because interest is a tax-deductible expense. (Study Session 8, LOS 29.l)

A)	Management may believe that now is an opportune time to issue equity.

B)	There may be economies of scale in issuing debt securities.

C)	The book values of outstanding debt and equity are different from their market values.

The book values of equity and debt are generally not relevant to assessing a firm’s capital structure. It is the market values of equity and debt that determine the current capital structure. (Study Session 8, LOS 29.m)

A)	A firm may be deterred from increasing the use of debt to avoid having its credit rating reduced below some minimum acceptable level.

B)	Because credit ratings are based upon cash flow coverage of interest expense, they are not influenced by the firm’s capital structure.

C)	Firms that have their credit ratings reduced below investment grade are not able to issue additional debt.

Credit ratings can be factored into management’s capital structure policy if a firm has a minimum rating objective, and this is likely to be adversely affected by issuing additional debt. (Study Session 8, LOS 29.n)

A)	Companies in countries where the use of bank debt (as opposed to issuing bonds) is more prevalent tend to use more leverage.

B)	The use of leverage in capital structures is broadly consistent in most developed economies.

C)	A high degree of information asymmetry tends to reduce the use of debt in the capital structure.

Companies in countries where the use of bank borrowing is relatively more prevalent than the issuance of corporate bonds tend to use more leverage. The other statements are incorrect, based upon observations across countries. (Study Session 8, LOS 29.p)

Katherine Epler, a self-employed corporate finance consultant, is working with her newest client, Harbor Machinery. Epler is discussing various capital structure theories with her client, and makes the following comments.

Comment 1: If we remove the assumption of no taxes from Modigliani and Miller’s theory regarding capital structure, and if the firm holds some proportion of debt, increases in the corporate tax rate will increase the value of the firm.

Comment 2: If we also include the costs of financial distress in Modigliani and Miller’s assumptions, the optimal capital structure will not contain any debt financing.

Epler’s first comment is correct. The tax deductibility of interest payments provides a tax shield that adds value to the firm. The value of a tax shield is equal to the marginal tax rate times the amount of debt in the capital structure, so the higher the tax rate, the greater the value of the tax shield and the value of the firm, all else equal. Epler’s second comment is incorrect. If the costs of financial distress are also included in MM’s assumptions, we get the static-tradeoff theory, where the firm will have debt in its capital structure up to the point where the marginal cost of financial distress exceeds the marginal value provided by the tax shield.

Davis Streng, the corporate controller for the Cannizaro Corporation has been researching Modigliani and Miller’s (MM) theories on capital structure. Streng would like to apply the theories to his firm’s capital structure, but does not agree with MM’s assumption of no taxes, since Cannizaro has a 40% tax rate. If Streng removes the assumption of no taxes, but keeps all of MM’s other assumptions, which of the following would be the optimal capital structure for maximizing the value of the firm?

A)	The capital structure Streng chooses is irrelevant.

B)	100% debt.

C)	100% equity.

If MM’s other assumptions are maintained, removing the no tax assumption means that the value of the firm is maximized when the value of the tax shield is maximized, which occurs with a capital structure of 100% debt.

Rupert Jones, a manager with Oswald Technologies, is confused about agency costs of equity and how they can be managed at his firm. To try to gain a better understanding about agency costs, Jones asks Karrie Converse, a well known consultant for an explanation. In their conversation, Converse makes the following statements:

Statement 1: Costs related to the conflict of interest between managers and owners of a business can be eliminated through a combination of bonding provisions and adequate monitoring through a quality corporate governance structure.

Statement 2: The less a company depends on debt in its capital structure, the lower the agency costs the company will tend to have.

Both of Converse’s statements are incorrect. With regard to elimination of agency costs, residual losses may occur even with adequate monitoring and bonding provisions, because such provisions do not provide a perfect guarantee against losses. Also, if you read the statement carefully, it is contradictory because the costs associated with bonding insurance and monitoring are actual agency costs! The second statement is also incorrect because, according to agency theory, the use of debt forces managers to have discipline with regard to how they spend cash. This discipline causes greater amounts of leverage to correspond to a reduction in agency costs.

Which of the following companies is most likely to have the greatest expected cost of financial distress?

A)	An airline company with strong management.

B)	A steel manufacturer with an average debt to equity ratio for the industry.

C)	An information technology service provider with a weak corporate governance structure.

The expected cost financial distress is related to the combination of the cost and probability of financial distress. Firms who have a ready secondary market for their assets such as airlines or steel manufacturers, have lower costs from financial distress due to the marketability of their assets. Firms with fewer tangible assets, such as information technology service providers, have less to liquidate and therefore have higher costs related to financial distress. The probability of financial distress is positively related to the amount of leverage on the balance sheet, and negatively related to the quality of a firm’s management and corporate governance structure.

Which of the following is least likely to be categorized as a cost of financial distress?

A)	Legal fees paid to bankruptcy lawyers.

B)	Having a potential merger partner pull out of a proposed deal.

C)	Premiums paid for bonding insurance to guarantee management performance.

Premiums paid for bonding insurance to guarantee management performance is an example of an agency cost. Agency costs are costs associated with the fact that all public companies are not managed by owners and the conflict of interest created by that fact. Costs of financial distress can be direct or indirect. Direct costs would include cash expenses associated with bankruptcy, such as legal and administrative fees, while indirect costs would include foregone business opportunities, inability to access capital markets, or loss of trust from customers, suppliers, or employees.

Which of the following is likely to encourage a firm to increase the amount of debt in its capital structure?

A)	The corporate tax rate increases.

B)	The personal tax rate increases.

C)	The firm's earnings become more volatile.

An increase in the corporate tax rate will increase the tax benefit to the corporation, because interest expense is not taxable. An increase in the personal tax rate will not impact the firm’s cost of capital. More volatile earnings increase the risk of the firm and therefore the firm would not desire to increase financial risk as a result of these changes.

Which of the following firms is most likely to utilize additional debt the next time it raises capital? The firm:

A)	that has many new fixed assets.

B)	in a high tax bracket.

C)	firm that has experienced significant losses in recent years.

The value of tax deductibility rises with tax rates. Of course, there are other ways to reduce taxes. Firms with many new assets are probably also benefiting from high levels of depreciation. Firms with recent losses may be avoiding taxes by writing off those losses.

Bhairavi Patel, an analyst for major brokerage firm, is considering how to incorporate the static trade-off capital structure theory into her valuation models for companies she covers. Patel is discussing the static trade-off theory with her colleagues, and makes the following statements:

Statement 1: If a firm maintains a high debt rating, the firm cannot be at its optimal capital structure based on the static trade-off theory.

Statement 2: The static theory implies that differences in the optimal capital structure across similar firms in different countries must be the result of different tax rates in those countries.

Neither of Patel’s statements is correct. Firms seek to maintain a high debt rating because it implies a lower probability of financial distress, which reduces the cost of debt and equity capital and leads to a higher value for the firm. Although a firm would not be at its optimal capital structure if it were not using enough debt, a firm can certainly have a large proportion of high quality debt that keeps the firm at its optimal capital structure while maintaining a high credit rating. The second statement is also incorrect. Although differences in tax rates can play a role in having different optimal capital structures for similar firms, differences in costs of financial distress will play a role as well. Differences in legal structure, liquidity, and other factors will result in different perceived costs of financial distress in different countries, which will in turn, contribute to different optimal capital structures according to the static trade-off theory.

Katherine Epler, a self-employed corporate finance consultant, is working with another new client, Thurber Electronics. Epler is discussing the static trade-off capital structure theory with her client, and makes the following comments:

Comment 1: Under the static trade-off theory, the graph of a company’s weighted average cost of capital has a U shape.

Comment 2: According to the static trade-off theory, every firm will have the same optimal amount of debt that maximizes the value of the firm.

Epler’s first comment is correct. When graphing a company’s WACC according to the static trade-off theory, the WACC will initially decline as a company increases its tax savings through the use of debt. However, as more debt is added, the WACC will reach a point where it increases due to the increasing costs of financial distress. Note that when graphing the static trade-off theory, the WACC looks like a U shape, while the value of the firm looks like an upside down U shape. This makes sense because the value of the firm is maximized when the WACC is minimized. Epler’s second comment is incorrect. Every firm will have a different optimal capital structure that will depend on the firm’s operating risk, tax situation, industry influences, and other factors.

A)	there is an optimal proportion of debt that will maximize the value of the firm.

B)	new debt financing is always preferable to new equity financing.

C)	the amount of debt used by a company should decrease as the company’s corporate tax rate increases.

The static trade-off theory seeks to balance the costs of financial distress with the tax shield benefits from using debt. Under the static trade-off theory, there is an optimal capital structure that has an optimal proportion of debt that will maximize the value of the firm.

Which of the following best describes the shape of the line depicting the value of a levered firm when plotted according to the static trade-off theory? Assume that the percentage of debt in the capital structure is the independent variable.

The line depicting the value of a levered firm according to the static trade-off theory looks like an upside down U. The value of the firm will initially increase due to the tax savings provided by taking on additional debt financing, and then will decline as the costs of financial distress exceed the tax benefits of taking on additional debt financing.

Global Development expects to earn $6 million next year. 40% of this amount, or $2.4 million, has been allocated for distribution to common shareholders. There are 2.4 million shares outstanding, and the market price is $30 a share. If Global uses the $2.4 million to repurchase shares at the current price of $30 per share, its share price after the repurchase will be closest to:

Market value of equity before the repurchase is $30 × 2.4 million = $72 million.

Shares Repurchased = $2.4 million / $30 = 80,000 shares.

Shares remaining = Shares outstanding ? Shares repurchased = 2,400,000 ? 80,000 = 2,320,000.

Share price after the repurchase = ($72 million ? $2.4 million) / 2,320,000 = $30.

John Harrison is discussing the implications for Modigliani and Miller (MM’s) propositions (assuming no corporate or personal taxes) for manager’s decisions regarding capital structure with his supervisor, Harriet Perry. In the conversation, Harrison makes the following statements:

Statement 1: According to MM’s propositions, increasing the use of cheaper debt financing will increase the cost of equity and the net change to the company’s weighted average cost of capital (WACC) will be zero.

Statement 2: Since MM’s propositions assume that there are no taxes, equity is the preferred method of financing.

Perry should agree with the first statement. MM asserts that the use of debt financing, although it is cheaper than equity, will increase in the cost of equity, resulting in a zero net change in the WACC. Perry should disagree with the second statement. Although MM’s propositions assume that there are no taxes, the conclusion is that the mix of debt and equity financing is irrelevant and that there is no preferred method of financing.

According to pecking order theory, which financing choice is most preferred, and which is least preferred?

Internally generated funds

New equity

New debt

New equity

Internally generated funds

New debt

Pecking order theory is related to the signals management sends to investors through its financing choices. Financing choices follow a hierarchy based on visibility to investors with internally generated funds being the least visible and most preferred, and issuing new equity as the most visible and least preferred.