Question Details

86. Draw the following two graphs, one above the other: In the top graph, plot firm value on the

vertical axis and total debt on the horizontal axis. Use the graph to illustrate the value of a firm under

M&M without taxes, M&M with taxes, and the static theory of capital structure. On the lower graph,

plot the WACC on the vertical axis and the debt-equity ratio on the horizontal axis. Use the graph to

illustrate the value of the firm's WACC under M&M without taxes, M&M with taxes, and the static

theory. Briefly explain what the two graphs tell us about firm value and its cost of capital under the

three different theories.

The student should replicate and explain Figure 17.8 from the text.

87. Based on M&M with and without taxes, how much time should a financial manager spend

analyzing the capital structure of a firm? What if the analysis is based on the static theory?

Under either M&M scenario, the financial manager should invest no time in analyzing the firm's

capital structure. With no taxes, capital structure is irrelevant. With taxes, M&M says a firm will

maximize its value by using 100 percent debt. In both cases, the manager has nothing to decide. With

the static theory, however, the manager must determine the optimal amount of debt and equity by

analyzing the tradeoff between the benefits of the interest tax shield versus the financial distress

costs. Finding the optimal capital structure is challenging in this case.

Chapter 017 Financial Leverage and Capital Structure Policy

www.sudanpoint.com/mba

17-25

88. What is homemade leverage and what is its significance to a firm?

Homemade leverage is the ability of investors to alter their own financial leverage to achieve a

desired capital structure no matter what a firm's capital structure might be. If investors can use

homemade leverage to create additional leverage or to undo existing leverage at their discretion then

the actual capital structure decision of the firm itself becomes irrelevant.

89. In each of the theories of capital structure, the cost of equity increases as the amount of debt

increases. So why don't financial managers use as little debt as possible to keep the cost of equity

down? After all, aren't financial managers supposed to maximize the value of a firm?

This question requires students to differentiate between the cost of equity and the weighted average

cost of capital. In fact, it gets to the essence of capital structure theory: the firm trades off higher

equity costs for lower debt costs. The shareholders benefit (to a point, according to the static theory)

because their investment in the firm is leveraged, enhancing the return on their investment. Thus,

even though the cost of equity rises, the overall cost of capital declines (again, up to a point

according to the static theory) and firm value rises.

90. Explain how a firm loses value during the bankruptcy process from both a creditor and a

shareholder perspective.

The bankruptcy process is a legal proceeding that either liquidates or reorganizes a firm. Under either

situation, legal, accounting, and other administrative fees are incurred. These fees, which are

frequently quite substantial, must be paid out of the assets of the firm, thereby reducing the value

remaining for the creditors and shareholders. In addition, the bankruptcy process generally transfers

value from the shareholders to the creditors based on the absolute priority rule.