FIN2014 Workshop 2023

Workshop 6 – Capital structure in a perfect market

Question 1
Why are the value and cash flows of levered equity less than if the firm had issued unlevered
equity?

Question 2
A firm expects free cash flow of $10 million each year. Its unlevered cost of capital is 10%. The
firm also has outstanding debt of $35 million, and it expects to maintain this level of debt
permanently. There are no corporate taxes or other market imperfections

Question 3
Table 1: Capital structures for U.S Industries

Industry Ratio of debt to equity Representative companies

Dairy products 68.76% Arla Foods, Danone
Fabric apparel 16.22 Columbia Sportswear
Paper 11.45 Avery Dennison
Drugs 6.82 Pfizer, Merck
Petroleum 28.70 ExxonMobil
refining
Steel 53.11 US Steel
Computers 11.96 Cisco, Dell
Motor vehicles 35.79 Ford, General Motors
Airlines 179.97 Delta, Southwest
Cable television 61.89 Cox Communication
Electric utilities 96.20 Southern Co.
Department stores 85.63 Nordstorm
Eating places 36.57 McDonalds, Wendy’s
Refer to the observed capital structures given in Table 1. What do you notice about the types of
industries with respect to their average debt-equity ratios? Are certain types of industries more
likely to be highly leveraged than others? What are some possible reasons for this observed
difference? Do the operating results and tax history of the firms play a role? How about their
future earnings prospects? Explain.

Question 4
Donkey Kong Corporation has a WACC of 16 percent. Its cost of debt is 13 percent. If Donkey
Kong’s debt-equity ratio is 2, what is its cost of equity capital. Ignore taxes in your answer.
 FIN2014 Workshop 2023

Question 5
Tinky Winky Inc. has no debt but can borrow at 7.5%. The firm WACC is currently 10%. Ignore
taxes.
a) What is Tinky Winky’s cost of equity?

b) If the company converts to 25% debt, what will it cost of equity be?

c) If the firm converts to 50 percent debt, what will it cost of equity be?

d) Assuming now there are taxes. what is the after-tax WACC for part (b) and part (c).
Corporate taxes is 35%

Question 6
How does the Modigliani-Miller model with taxes differ from the original theorem
without taxes?
The original MM theorem argues that a firm’s value is unaffected by its capital structure under
perfect conditions, including no taxes. Later one, MM revised their model to account for
corporate taxes. The revised model incorporates the concepts of tax shield which arises from
tax-deductible interest expense on debt.
According to the MM theorem with taxes, the value of a firm is equal to an unlevered firm’s
value plus the tax shield’s present value. Therefore, unlike the original model, the revised model
implies that a firm’s capital structure can impact its value due to the tax benefits of debt
financing.

Question 7
According to the Modigliani-Miller theorem with taxes, should firms take on more or less
debt?.
The theorem suggests that in a world with taxes, firm should increase their level of debt to
maximize the benefits of the tax shield and thus their value.
Up to a certain point, company value can be increased by adding leverage through tax benefits
created by interest payments on debts. At some point, the company will reach its optimal capital
structure; adding further leverage will increase the cost of financial distress faster than the
benefits gained from tax shelter.