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21 CAPITAL STRUCTURE
Introduction
Capital Structure Research
Modigliani-Miller - Proposition I
M & M - Proposition II
M & M and Taxes (M & M Corrected)
Debt and Taxes
Review of Miller and Modigliani
Relaxing Other Assumptions
Pecking Order Theory
Creative Financial Instruments
Debt is Better
Summary
Introduction
The question of what is an optimal capital structure for a firm continues to be at
the core of research in the finance area. If there is a correct relationship between
debt and equity then it would benefit a company to implement it.
This chapter considers research in finance and reviews some research milestones.
These landmarks indicate the direction of thinking in the area of capital structure.
While there have been some consequential research conclusions, theories on capital
structure are still evolving. The search for an optimal capital structure must be
seen within the context of that research, since what is correct changes over time,
changes between firms and can have different meaning for different people.
Capital Structure Research
Finance theories on the subject of capital structure have followed two broad
approaches since they began in 1958. The initial work by Miller and Modigliani
was a mathematical theory which they subsequently adapted to better reconcile it
with the real world. With the focusing of attention on capital structure by Miller
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424 Financial Management and Decision Making
and Modigliani, further research followed. Much of this later work followed an
alternative approach to research which was one of observing the finance world and
drawing conclusions from what was happening. The approach of Miller and
Modigliani was largely deductive, whereby particular predictions are made from
theory. The second approach is essentially inductive and positivist whereby theory
is derived from numbers of observations. In practice, research and knowledge
gathering is a mixture of these two approaches, the emphasis shifting depending on
the nature of the problem and the view of the researcher.
Jensen, one of the later researchers, suggests that we are entering a new era of
thinking on capital structure. Between Miller and Modigliani and Jensen, several
important milestones have been passed. Pecking order theory, the introduction of
new financial instruments and agency theory are a few of the more important
developments.
Modigliani-Miller - Proposition I
The work of Miller and Modigliani resulted in the assertion that:
The market value of any firm is independent of its capital structure
and is given by capitalizing its expected return at the rate appropriate
to its [risk] class.
(Modigliani, F. & Miller, M.H., 1958, p. 268)
This has become known as M & M Proposition I.
They arrived at this conclusion by making several assumptions about the financial
world and then mathematically proving that capital structure did not affect the value
of the firm. Their assumptions (both implicit and explicit) were:
- Capital markets are frictionless, i.e. there are no transaction costs.
- Individuals can lend and borrow at the same risk-free rate.
- There are no costs to bankruptcy.
- There are only two sources of finance for a firm, debt and equity.
- All firms are in the same risk class.
- There are no taxes (this assumption was later discarded).
- All cash flows are perpetuities, without growth.
- Corporate insiders have no more information about the firm than the
outsiders.
- Managers always act to maximise shareholders wealth.
While many of these assumptions may appear unrealistic they, and the resulting
conclusion, set the direction for future developments in this area. An example may
best show how M & M reached their conclusion.
Example Two firms, A and B, are identical except for their capital structure. Both firms are
the same size, both in the same line of business, and both generate the same revenue
and operating profits. Firm A is financed totally by equity. Firm B, on the other
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Chapter 21: Capital Structure 425
hand, has 60% equity and 40% debt. If firm B is more valuable than firm A, then
there must be value to their capital structure. If both firms have the same value,
then their capital structure must be irrelevant.
Assume that both firms have:
- total assets of $200m,
- revenue of $100m,
- production and operating costs of $80m
- the risk free interest rates is 10%.
Their Income Statements would then be:
($m) A B
Revenue 100 100
Less production and operating costs 80 80
Earnings before interest 20 20
Interest on debt 0 8
(Note: Firm B has debt of 40%,
or $80 of $200)
Net Income 20 12
It would cost $200m to own all the assets of A and this investment would be
entirely in equity. To own all of firm B, it would also cost a total of $200m but
would take two different forms. Only $120m of the investment would be in the
form of equity and $80m would be in the form of debt.
If value is measured by the total cash coming out of the company into the hands of
the owners, then it is necessary to see if both A and B generate the same cash to
their owners. Firm A generates $20m. Firm B only pays out $12m to the owners
from their operations. But being the owner of firm B means that not only is the
equity owned, but so is the debt. Therefore, the owners of firm B also received the
interest income of $8m, for a total income of $20m. If these income streams
coming from firms A and B continue as perpetuities, it is clear that both A and B
have the same value.
This result seems so straightforward. Nevertheless, this simple result has some
profound implications. Remember that one of the assumptions was that all
individuals and corporations could lend or borrow at the same risk free rate.
Assume that an investor, Sue, wants to invest in company A and she only has $12m.
Sue knows that financial leverage (i.e. the existence of debt) increases the return on
her investment if the firm is operating above the breakeven point. (See chapter on
Leverage as Risk.) Sue is therefore unhappy about the capital structure of firm A.
Sue could go to the bank on her own account and borrow money. She could add
this borrowed money to her own money to make a total investment in company A.
The result would be the same as if she had invested in just the equity of company B
with her original equity.
If she had used her $12m to hold equity in B, she would have owned 12/120, or
10% of the equity of B. This ownership would have entitled her to receive 10% of
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426 Financial Management and Decision Making
the Net Income, or $1.2m. On the other hand, to own 10% of firm A would require
more than her $12m since the total equity of firm A is $200m. In fact, Sue would
have to borrow $8m in order to own 10% of A. If she did, she would be entitled to
10% of the Net Income of A, $2m but she would then have to pay interest on her
personal debt totalling $.8m ($8m borrowed times 10% interest), leaving her with
$1.2m in net income. Thus, the investor creates her own financial leverage, she
does not need the company to do it for her.
Likewise, if Sue wanted to invest in company B, but would rather not have any
financial leverage, she could undo the leverage by lending some of her money at the
risk free rate.
This ability of the individual to create or undo financial leverage implies that any
capital structure that a firm may choose can be adjusted by the investors themselves.
If investors can pick their own preferred capital structure, why should a firm believe
it can increase investor wealth by settling on any one particular debt to equity ratio?
Given the assumptions of M & M, the capital structure of a firm does not matter.
M & M - Proposition II
Proposition I focused on the value of the firm. Proposition II focuses on the
expected return on equity of a company with various capital structures. M & Ms
Proposition II is that the expected return on equity increases linearly as the amount
of debt increases - provided that the debt remains risk free. But if increased debt
levels increase the cost of debt, this also causes the rate of increase in the expected
return on equity to decline. This is shown in Exhibit 21.1.
Exhibit 21.1 Expected
Rate of Return
Risk Free Debt
Expected Return on Equity
(including changes to
the expected return on equity
due to changes in the
expected return on debt)
Return on Assets
Expected Return on Debt
Risky Debt
Amount of Debt
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Chapter 21: Capital Structure 427
Since the sum of the returns to debt and equity must equal the total return generated
by the assets of a company, it is possible to write the return on assets as follows:
E(r
a
) = E(r
d
) x (% of Debt) + E(r
e
) x (% of Equity)
where E(r
a
) is the expected return on assets
E(r
d
) is the expected return on debt
E(r
e
) is the expected return on equity
Note: E(r
a
) is the cost of capital for the company (see Chapter 17)
Rewritten, this equation becomes:
E(r
a
) = [E(r
d
) ( D / (D+ E))] + [E(r
e
) ( E / (D+ E))]
and solving this equation for E(r
e
):
E(r
e
) = E(r
a
) + D / E ( E(r
a
) - E(r
d
) )
Thus, proposition II shows mathematically that the expected return on equity
increases as the amount of financial leverage increases, unless the expected return
on debt rises. This rise in the expected return on debt will only happen when the
debt holders feel they have lent more than can be justified at the risk free rate.
The implications of this proposition affect the Weighted Average Cost of Capital
(WACC) (see chapter on Cost of Capital). If the return on equity rises as the
amount of debt rises, then it is in the best interest of the equity holders to have a
large amount of debt. From the point of view of the company, large amounts of
debt reduce the WACC, another positive development. Thus, it may seem that
considerable debt is better than less debt.
However, traditionalists reviewing the working financial world argue that equity
holders are not lacking in common sense. They note that equity holders will require
a larger return on their equity investment when the cost of a companys borrowing
begins to exceed the risk-free rate. Equity holders know that there is more risk
when the company has more financial leverage and they demand to be paid for this
risk. Equity holders also require a higher return because companies who provide a
service of creating high amounts of financial leverage (i.e. high debt/equity ratios)
trade at a premium to their true market price.
Thus, the theoretical world of M & M is adjusted by real world observations. It is
clear that there is a point at which the cost of capital (weighted average cost of the
debt and the equity) is lowest. That point is before equity holders and debt holders
both start requiring additional return for the increased amount of debt carried by the
company. This is shown in Exhibit 21.2.
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428 Financial Management and Decision Making
Exhibit 21.2 Rates of Return
R
a
min D/E = Debt/Equity
R
d
R
a
(traditional)
R
a
(MM)
R
e
(MM)
R
e
(traditional)
M & M and Taxes (M & M Corrected)
When the assumption of no taxes in the original model is relaxed (and the other
assumptions remain in place) M & M (1963) adjust their view of the optimal
capital structure. The existence of corporate taxes in the real world results in added
value to the firm that has debt. This added value due to the existence of taxes is
called a tax shield.
Example Using the earlier example of firms A and B and introducing a corporate tax rate of
40%, the concept of a tax shield can be illustrated. Recall that firm A was totally
equity financed and firm B had 40% debt. Starting with the Net Income figure as
calculated earlier, this results in:
($m) A B
Net Income (before tax) 20 12.0
Less tax at 40% 8 4.8
Profit after Tax 12 7.2
and the total cash flow to the owners now becomes:
($m) A B
Total return on equity 12 7.2
Plus Interest income 0 8.0
Total Cash to Owners 12 15.2
Thus, the existence of taxes combined with the ability to reduce taxable income by
the amount of interest expense results in increased cash flowing out of the company
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Chapter 21: Capital Structure 429
with more debt. This implies that having debt results in a higher value to the
owners.
Debt and Taxes
In 1977, Miller looked more closely at the issue of taxes. He suggested that the
important result is not solely how much money flows out of the company, but how
much the owners retain after being taxed on cash received from the company.
Example Assume that no tax is paid at the personal level on income received as a result of
owning equity but that tax is paid on interest income at the same rate as company
tax (40% in our example). Under these conditions, there is no difference between
owning firm A or B as follows:
($m) A B
Total Cash to Owners 12 15.2
Less personal tax on
interest income at 40% 0 3.2
Total personal net income 12 12.0
If the personal tax rate is higher than the corporate rate, it is clear that income at the
personal level due to equity is more favourable than income from holding debt. On
the other hand, if the personal tax rate is lower than the corporate rate, it would be
better if personal income was derived by holding debt in lieu of equity.
This further consideration of the tax issues involved in maximising shareholders
wealth leads to an examination of the clientele effect. Some shareholders prefer a
capital structure with more equity while others prefer one with more debt. The
choice depends on the tax structure of the shareholders. It is also possible that
owners will have to pay tax on their equity income, further complicating the
analysis.
Therefore, each individual investor will assess which particular capital structure
best suits their needs making it impossible to formulate a general rule for an
optimal structure. (Dividend policy is also partially influenced by a clientele
effect.)
Review of Miller and Modigliani
M & M set the direction for research in the area of capital structure. Their
approach was a deductive one, having a range of assumptions about the world
which permitted their mathematical analysis to reach a clear conclusion. Their
conclusion was that capital structure did not affect the value of the firm, so it did not
matter - any capital structure was as good as any other.
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430 Financial Management and Decision Making
One of the more important implications of their analysis was that any individual
could create or undo financial leverage at a personal portfolio level. This was seen
as added confirmation that the capital structure did not matter.
After ther initial work, M & M relaxed one of their assumptions acknowledging that
there are corporate taxes. Furthermore, they noted that in the world of tax, interest
expense reduced taxable income, thus creating a tax shield. The tax shield
increased the present value of the cash flowing out of the firm. At this point in their
analysis, the conclusion was that it was better to have debt than to be all equity
financed.
When M & M looked at the return to the equity owners of the firm, they noticed
that the return increased as the amount of debt increased, provided that the cost of
debt remained at the risk free rate. This confirmed their view that the existence of
debt in the capital structure of the firm was better for the equity holders.
Miller then examined the personal wealth of the owners of the firm after they paid
personal tax (keeping all other assumptions in place). If the owners tax rate was
0% on income from equity (i.e. net income from the company) and the same tax
rate on interest income as the company tax rate, then the net cash flow to the owners
would be the same regardless of the capital structure of the firm. In this case, Miller
reasoned, the capital structure is irrelevant. However, owners of firms may well
have tax rates different to that of the firm itself and thus Miller asserted that the
proper capital structure for a firm depended upon the tax rates being paid by the
firm and by the owners. In other words, capital structure decisions must consider
the client (owners). Some owners may prefer more debt in the corporation, others
may prefer more equity. Therefore, each possible capital structure could attract a
client (owner). Instead of saying that capital structure does not matter, Miller
suggests that it does, but since there are so many owners with various tax rates and
firms with various tax rates, most capital structures would attract a client(s).
When M & M looked at the actual capital structures of the corporations in the
market place, they found a wide range of debt/equity ratios. The concept of
irrelevance appeared to suit what was happening in the real world. When they
corrected their model and suggested that debt created a tax shield and thus
increased the value of a firm, they were suggesting, indirectly, that managers of
firms with little debt were not serving their shareholders properly. Nevertheless, the
large variance in debt to equity ratios did not change. In 1977 Miller returned to a
theory of capital structure which could explain this wide range of debt/equity ratios
that existed in the market place.
Several studies have examined the value added to firms when they increase their
leverage. On balance, there is only weak confirmation that increased debt increases
value. (Copeland, T.E. & Weston, J.F., 1988 review many of these studies.)
Relaxing Other Assumptions
Each of the other assumptions of M & Ms original model have been examined by
various studies. The existence of transaction costs (friction) and differences
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Chapter 21: Capital Structure 431
between the cost of lending or borrowing tend to make little difference to the
analysis of capital structure.
Relaxing the assumption that there are no costs associated with bankruptcy has
resulted in considerable study. As a firm gathers too much debt, it becomes
possible for the equity holders to profit at the expense of the debt holders. This has
led the debt holders to put restrictions - including a maximum amount of debt
permitted - into their loan agreements. Thus, there seems to be an upper limit to the
amount of acceptable debt.
The assumption that only debt and equity are available to finance firms is now
being challenged by the creative marketing skills of the finance industry.
Assuming that corporate insiders and outsiders have the same information is also
now being challenged and a pecking order theory of capital structure has emerged.
Jensen challenged the assumption that managers always maximize shareholders
wealth. This conflict led to Jensens view that agency theory must also be
considered. This theory is leading to a new view of capital structure.
Pecking Order Theory
In 1984, Myers suggested another view of why firms have a particular capital
structure. By examining what is happening in firms, a pecking order of capital
structure has been formulated.
This theory suggests that a firms capital structure is more a by-product of the
pecking order rather than a specifically targeted relationship between debt and
equity. When firms need finance, they adhere to the following pecking order to get
the money:
1. First they use internally generated funds, i.e. retained earnings.
2. They adjust their target dividend payout to accommodate their investment
opportunity without causing sudden changes in the dividend flow.
3. If external finance is required, firms prefer (in order of preference):
- debt
- hybrids between debt and equity (such as convertible bonds)
- equity as a last resort.
This means that capital structure is only the result of the financing needs of a firm.
If a company is profitable, it does not need to raise funds externally. If it has been
profitable for a long time, it is probable that it will have a low debt/equity ratio. On
the other hand, if a firm is growing fast and has exhausted all internal sources of
finance, it will issue new debt before issuing new equity. Thus, it is likely to have
higher financial leverage.
This is a dynamic theory of capital structure and there is no attempt to establish and
maintain a specific debt/equity ratio; rather, managers take the line of least
resistance in raising funds. It is easier to use company money than to borrow
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432 Financial Management and Decision Making
money. It is easier to deal with a lender than to comply with all of the requirements
of issuing new equity. Perhaps it is just a matter of avoiding the friction of
transaction costs which leads managers to behave this way. Others suggest that this
behaviour is because it makes management easier, requiring less of their time and
energy to work down the pecking order than to maintain a specific capital structure.
Support is growing for this theory.
Creative Financial Instruments
The clear line between debt and equity has been blurred with the use of innovative
financial instruments. This blurring means that traditional classifications of either
debt or equity are no longer as meaningful.
Some of these instruments include:
- Convertible Bonds: this is a combination of two securities, a straight debt
issue and a right to convert this debt into shares of equity.
- Call provisions on debt: this part of the debt contract permits the firm to
redeem the debt prior to the maturity date.
- Preferred Stock: these are typically voting shares carrying with them a
coupon rate of payment on a face value. These instruments receive income
as if they were debts of the firm, but their holders cannot force bankruptcy,
and they have voting rights.
- Lines of Credit: firms often arrange a line of credit from a bank (or a
syndicate of banks) which permits them to use these funds as they are
needed. This could put, for example, $1 billion of debt at the firms
disposal, but it is only used if needed.
These instruments along with the traditional off Balance Sheet items, for example,
leases, interlocking holdings, and contingent liabilities, make the problem of
establishing the actual capital structure of a firm extremely difficult.
Debt is Better
A period of significant change in the capital structure of many major firms began in
the late 1980s. These changes have come on the back of large waves of mergers
and acquisitions (M & As), leveraged buy outs (LBOs), and management buy outs
(MBOs). These changes in ownership of firms have, for the most part, been paid
for with borrowed money. This borrowed money has then ended up on the balance
sheets of the firm. Debt/asset ratios have risen as high as 85% (from a previous
average of about 50%).
With the extremely high levels of financial leverage the financial risk of running
these firms has also increased. Kaplan documents many of these changes. He
studied all public company buyouts with a minimum purchase price of $US50m in
- .
Chapter 21: Capital Structure 433
the USA from 1979 to 1985. Not only do these firms add large amounts of debt,
but they generate large profits for the active investors that buy the companies.
Kaplan found that the salaries of the LBO business unit managers were 20 times
more sensitive to performance than those in the typical public company. He also
found that if the company is resold to the public again, total shareholder value
increases 100% above the risk adjusted market returns over the same period.
These large profits in the hands of the few LBO (and MBO) managers and owners
have generated a lot of publicity. Not surprisingly, there is jealousy among those
not making the profits, and resentment among those managers losing their jobs.
Much of the criticism centres on the high debt levels remaining in the firm. The
critics argue that so much debt in so many companies could lead to the collapse of
several companies if a recession should occur since a recession would reduce the
cash flow necessary to service the high amounts of debt. If it were not for the tax
deductibility of interest expense, these buyouts would not be using so much debt
and, the critics maintain, such large amounts of debt can only be bad because of all
the risks associated with debt.
Jensen sees this evolution toward high debt levels as the beginning of the end of the
public corporation as we know it. This development, he asserts, is a good thing.
Some of the reasons for positively viewing this move to extremely high debt levels
include:
1. More tax is paid to the government through these transactions, not less.
2. Increased borrowing forces the management of the company to part with the
cash it generates via interest expense payments.
3. Large amounts of debt will force a company to restructure itself as soon as
problems develop, not permit the company to squander its wealth while
remaining in a poor business situation.
4. The market place is better than the management of any company at allocating
capital among competing businesses and then monitoring performance.
5. Debt forces managers to disgorge cash rather than waste or hoard it. Interest on
debt is more reliable as a cash flow than dividend payments.
Jensen is essentially questioning the final assumption of M & M. His agency
theory suggests that management does not work for the best interests of the
shareholders, but is more interested in protecting management jobs and perks. The
high debt levels forced upon companies by LBOs free up hoards of cash and permit
the active investors to decide where that cash should then be invested.
Therefore, Jensen believes that a new organisational form, which he calls an LBO
Association is a more efficient and effective form of business organisation and he
views the change as being the most profound change to business organisation since
World War II.
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434 Financial Management and Decision Making
Summary
The search for a theory to explain the capital structure of businesses continues. It is
one of the major focal points in the field of finance. By understanding the search
for an optimal capital structure it is possible to understand part of the foundations
of finance theory, the nature of financial research, and the current view on the
evolutionary nature of businesses.
Modigliani and Miller developed a model of capital structure based on deductive
and mathematical reasoning and concluded that capital structure was irrelevant to
the value of the business. Although higher levels of debt did affect the return on
equity, they argued that this was due to the increased financial risk borne by the
equity holders.
Subsequent studies have looked at how businesses actually arrive at their capital
structure and this has produced the pecking order theory, that businesses take the
path of least resistance in finding funds for investment. Thus, capital structure is a
by-product of the historical and current profitability of the business. In addition,
new creative financial instruments have made the actual process of defining a firms
capital structure more and more difficult.
The merger and buy-out activity of the 1980s has forced researchers to look closely
at the final assumption made by Modigliani and Miller, that managers always act to
maximise shareholders wealth. Kaplan and Jensen suggest that this it not so since
there are insufficient incentives. Jensen believes that the market place solves this by
taking publicly owned firms away from public ownership and running them as
private LBO Associations. This process uses large amounts of debt implying that
the market place considers the best capital structure to be a highly geared one.
Several sound reasons for the use of debt led Jensen to assert that this dynamic
change in the structure of public corporations is indeed good (i.e. better at
maximising the wealth of the owners) and will therefore continue. We are
witnessing a new phase in business structures and the search for the optimal capital
structure continues.
Glossary of
Key Terms
LBO (MBO)
Leveraged buy out and management buy out refer to highly levered purchases of
organisations.
M & M Propositions
Proposition I: That the value of any firm is independent of its capital structure
and is given by capitalising its expected return at the appropriate rate for its risk
class.
Proposition II: That the expected return on equity increases linearly as the
amount of debt increases provided that debt remains risk free. However, if the
cost of debt increases, the rate of increase in the expected return on equity
declines.
- .
Chapter 21: Capital Structure 435
M & M Corrected: That the existence of corporate taxes in the real world
results in added value to the firm that has debt.
Pecking Order
An order of preference for finance from internally generated funds through to equity
as a last resort.
Selected
Readings
Copeland, T.E. & Weston J.F., Financial Theory and Corporate Policy,
Addison-Wesley, 1988, pp 497-536.
Jensen, M.C., Kaplan, R. & Stiglin, L., Effects of LBOs on Tax Revenues of the
U.S. Treasury, Tax Notes, February 6, 1989
Jensen, M.C., Eclipse of the Public Corporation, Harvard Business Review,
Sept-Oct 1989, pp 61-74.
Jensen, M.C. & Murphy, K.J., Performance Pay and Top Management Incentives,
Journal of Political Economy, Vol 98 No 2, April 1990, pp 225-264.
Kaplan, S., Sources of Value in Management Buyouts, as reported in Eclipse of
the Public Corporation, Harvard Business Review, Sept-Oct 1989, pp 61-74.
Miller, M.H., Debt and Taxes, Journal of Finance, 32, May 1977, pp 261-276.
Modigliani, F. & Miller M.H., The Cost of Capital, Corporation Finance, and the
Theory of Investment, American Economic Review, June 1958, pp 261-297.
Modigliani, F. & Miller, M.H., Corporate Income Taxes and the Cost of Capital,
American Economic Review, June 1963, pp 433-443.
Myers, S.C., The Capital Structure Puzzle, Journal of Finance, July 1984, pp
575-592.
Myers, S.C. & Majluf, N., Corporate Financing and Investment Decisions When
Firms Have Information That Investors Do Not Have, Journal of Financial
Economics, June 1984, pp 187-221.
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436 Financial Management and Decision Making
Questions
21.1
What effect does the personal tax rate have on the following?
a. Net return to equity holders of a levered firm.
b. Net return to debt holders of a levered firm.
c. The value of the firm.
21.2
Company A and B are identical, except Company A is all equity financed and Company B has 30%
debt and 70% equity. You have $100 of your own money to invest.
Required:
a. How can you invest in Company B to give you the same risk exposure as if you invest in Company
A?
b. How can you invest in Company A to give you the same risk exposure as if you invest in Company
B?
c. If the corporate tax rate is 30% and your personal tax rate is 20%, which firm best suits your
needs? Why?
d. If both the corporate and personal tax rates are 35%, which firm best suits your needs? Why?
21.3
What accounting difficulties would prevent you from really knowing the capital structure of a firm
you may invest in?
21.4
Creative Financial Marketing affects corporate structure. How?
21.5
Agency Theory explains the relationship between management and owners. Discuss the
development of agency theory as presented in this chapter.
21.6
How could high levels of debt:
a. Increase corporate productivity?
b. Force companies to release cash hordes?
c. Hasten corporate restructuring?
d. Increase shareholder wealth?
e. Change the role of share markets?