13: Capital StructureProject 1: The opportunity to invest $7 million in risk-free Australian Government Treasury notes
with a 4% annual interest rate (or a 0.333% monthly interest rate)
Project 2: A high-risk gamble that will pay $12 million in one month if it is successful (probability
= 0.25), but will pay only $4,000,000 if it is unsuccessful (probability = 0.75).
a Compute the expected payoff for
each project. Which one would you
adopt if you were operating the
company in the shareholders’ best
interests? Why?b Which project would you accept if the
company were unlevered? Why?
c Which project would you accept if
the company were organised as a
partnership rather than a corporation?
Why?QUESTIONS
Q13-1 Why is the use of long-term debt financing
referred to as using financial leverage?
Q13-2 What is the fundamental principle of
financial leverage?
Q13-3 Following from the conclusion of
Proposition I, what is the crux of M&M’s
Proposition II? What is the natural
relationship between the required returns
on debt and equity that results from
Proposition II?
Q13-4 In what way did M&M change their
conclusion regarding capital structure
choice with the additional assumption
of corporate taxes? In this context, what
explains the difference in value between
levered and unlevered companies?
Q13-5 By introducing personal taxes into the
model for capital structure choice,
how did Miller alter the previous M&M
conclusion that 100% debt is optimal?
What happens to the gains from leverage
if personal tax rates on interest income
are significantly higher than those on
share-related income?
Q13-6 Why do a firm’s shareholders hold a
valuable ‘default option’? How could this
option induce shareholders to employ
high levels of financial leverage?
Q13-7 All else equal, which company would
face higher costs of financial distress:
a software development company,
or a hotel chain? Why would financial
distress costs affect these companies so
differently?
Q13-8 Describe how managers of companies
that have debt outstanding and face
financial distress, might jeopardise
the investments of creditors with
the games of asset substitution and
underinvestment.Q13-9 How can loan covenants in bond
contracts be both an agency cost of debt
and a way to prevent agency costs of
debt?
Q13-10 What are the trade-offs in the agency
cost/tax shield trade-off model? How is
the company’s optimal capital structure
determined under the assumptions of
this model? Does research evidence
support this model?
Q13-11 How influential are corporate and
personal taxes on capital structure?
Q13-12 What is the pecking-order theory,
and what facts does it seem to
explain better than the trade-off model
does?