MODULE-4

STRATEGIC FINANCING DECISIONS

1. Why are financing decisions, compares to investment decisions relatively easier to
make?
Ans:

Financing decisions Investment decisions

• Financing decisions take place in
capital markets which are
approximately perfect
• While making financial decisions you
can observe the value of similar
financial assets
• There are very few opportunities in
the realm of financing that have an
NPV that is significantly different
from zero
• Investment decisions take place in
real markets which tend to be
imperfect
• While making investment decisions,
you have to estimate the value of the
capital projects.
• There are many opportunities in the
realm of capital budgeting that have
an NPV that is significantly different
from zero.

2. State key propositions of Modigliani and Miller. Explain how the arbitrage
mechanism works.
Ans: key propositions of MM
• Capital markets are perfect. Information is freely available and transactions are
costless; securities are infinitely divisible.
• Investors are rational. Investors are well-informed and choose a combination of risk
and return that Is most advantageous to them.
• Investors have homogeneous expectations. Investors hold identical subjective
probability distributions about future operating earnings.
• Firms can be grouped into ‘equivalent risk classes’ on the basis of their business
risk.
• There is no corporate income tax.
Arbitrage Mechanism
• According to MM, if two firms, say X and Y, are in the same risk class and have
the same expected operating income they will have the same value in the
marketplace, irrespective of differences in their capital structure.
• If their value diverges, investors will resort to arbitrage. They will sell the securities
of the firm which has value and buy the securities of the firm which has a lower
value.
• The arbitrage actions of investors will bring about an equality in the value of the
two firms.
3. What is the value of a firm in the presence of corporate taxes?
Ans: when taxes are applicable to corporate income, debt financing is advantageous
because while dividends and retained earnings are not deductible for tax purposes, interest
on debt is a tax-deductible expense, as a result, the total income available for both
shareholders and debtholders is greater when debt capital is used.
Value of levered firm= value of unlevered firm+ debt* Tc

4. Discuss financial distress costs and agency costs.

Ans:
Costs of financial distress:
When a firm is unable to meet its obligations, it results in financial distress that can lead to
bankruptcy.
When a firm experiences financial distress several things can happen, they are:
• Arguments between shareholders and creditors delay the liquidation of assets
• Bankruptcy cases often take years to settle and during this period machinery and
equipment rust, buildings deteriorate, and inventories become obsolete.
• If assets are sold under distress conditions, they may fetch a price that is
significantly less than their economic value.
• The legal and administrative costs associated with bankruptcy proceedings are quite
high.
• Managers become myopic.
• Employees, customers, suppliers, distributors, investors, and other stakeholders
dilute their commitment to the firm.
Agency costs:
• There is an agency relationship between the shareholders and creditors of firms that
have substantial amounts of debts.
• In such firm shareholders have little incentive to limit losses in the event of
bankruptcy.
• Hence, managers acting in the interest of shareholders tend to invest in highly risky
and volatile projects that increase the wealth of shareholders at the expense of
creditors.
• Financial distress and agency costa, the value of a levered firm may be expressed
as:
Value of the levered firm= value of the unlevered firm + tax advantages of debt -
present value of financial distress costs - present value of agency costs
5. Discuss the tradeoff theory
Ans:
• According to the tradeoff theory, every firm has an optimal debt-equity ratio that
maximizes its value. At that optimal point, the tax advantage of debt is balanced by the
final distress costs and agency costs.
• The optimal debt-equity ratio of a profitable firm that has stable, tangible assets that
would be higher than the optimal debt-equity ratio of an unprofitable firm with risky
intangible assets.
• Because a profitable firm can avail of tax shelter associated with debt fully.
• Further, when assets are stable and tangible financial distress costs and agency costs
tend to be lower.

6. Explain signaling theory.

Ans: In a pioneering study published in 1961, Gordon Donaldson examined how
companies actually established their capital structure. The findings of his study are
summarized below:
• Firm prefers to rely on internal accruals, that is, on retained earnings and depreciation
cash flow.
• Expected future investment opportunities and expected future cash flow influence the
target dividend payout ratio.
• Dividends tend to be sticky in the short run.
• If a firm’s internal accruals exceed its capital expenditure requirements.
• If a firm’s internal accruals are less than its non-postponable capital expenditure.
according to signaling theory, there is a pecking order of financing which goes as follows
• Internal financing (retained earnings)
• Debt financing
• External equity finance

7. Discuss the key guidelines for capital structure planning

Ans:
• Avail of the tax advantage of debt
• Preserve flexibility
• Ensure that the total risk exposure is reasonable
• Subordinate financial policy to corporate strategy
• Resort to timing judiciously
• Finance proactively no reactively
• Know the norms of lenders and credit rating agencies
• Issue innovative securities
• Minimise investor conflicts
8. Explain the Miller and Modigliani dividend irrelevance theorem
Ans: MM have advanced the view that the value of a firm depends solely on its earnings
power and is not influenced by the manner in which its earnings are split between dividends
and retained earnings.
Assumptions:
• Capital markets are perfect and investors are rational
• Floating costs are nil
• No taxes
• Investment opportunities and future profits of firms are known with certainty
• Investment and dividend decisions are independent.

9. Discuss the rationale and objections to share buybacks.

Ans: rational for share buybacks:
• Efficient allocation of resources
• Positive signal
• Price stability
• Control
• Voluntary character
• No implied commitment
• Capital structure changes
Objections to buybacks:
• Unfair advantage
• Manipulation
• Excessive payment