Chambers and Lacey Modern Corporate Finance
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1 Chambers and Lacey Modern Corporate Finance Financial Leverage Discussion Questions 5th Edition Chapter 13 Problem Respond to the following statement: High debt usage by corporations drives up the riskiness of our country s economic base. It is important to recall from the chapter that the proportion between debt and equity in a firm's capital structure does not change the amount of risk contained in the firm's assets, it merely partitions the risk amongst the firm's security holders. Thus, the riskiness of a Country's economic base depends upon the real assets rather than upon the financial assets used in the capital structures of the corporations. Problem Respond to the following question: Highly levered firms outperformed all equity firms in the mid-to late 1980s and underperformed all equity firms in the early 1990s. How can modernists say that debt is irrelevant? The arguments of Chapter 13 claim that the use of a particular capital structure does not, by itself, change shareholder wealth. However, when the value of a firm's assets rises or falls through time, highly leveraged firms will have greater equity volatility than unlevered firms. Thus, after time passes, there will be an "after the fact", or an "ex post" optimum capital structure. Similarly, after a lottery drawing is held there will be an after the fact winning ticket. However, before the lottery drawing is held, all tickets are (generally speaking) equally valuable. We cannot know ahead of time whether economic events will unfold that will make leverage or lack of leverage the "after the fact" better choice. Problem Respond to the following question: Why are traditionalists incorrect in drawing the required rate of return as bending upward in leverage (a convex shape as shown in Figure 13.4), but modernists are correct in drawing the required rate of return as bending down in leverage (a concave shape as shown in Figure 13.5)? Return and risk must rise and fall together. Thus, Figures 13.4 and 13.5 can be viewed in terms of either risk or return. As leverage increases, three things generally happen: 1. the total risk remains the same, 2. the leverage causes the risk of the equity to increase, and 3. the leverage causes the debt holders to bear risk at an increasing rate. The first two points taken together would force a linear relationship between leverage and a return if debt were assumed to be risk free. Note that at very, very low levels of leverage, the debt holders bear virtually no risk. Financial Leverage 1 Discussion and Review Questions
2 Problem 4. As debt usage increases, eventually, the use of leverage can begin to cause the debt holders to bear non-trivial amounts of risk. Under reasonable assumptions, the amount of risk that the debt holders bear can be shown to increase at an increasing rate. Putting the concepts together, we can think of a firm with almost no leverage and with risk-free debt beginning to increase its debt level. At first, the increased leverage causes virtually no increase in the riskiness of the debt and therefore the increased leverage causes the risk and return and of the equity to grow in a linear fashion. However, as the increased leverage begins to shift some of the risk to the debtholders, the amount of increased risk that the equity holders must bear begins to slow. This causes the line in the Figures for equity to bend in a concave manner. 4. Respond to the following statement: There are some financial managers who pay a great deal of attention to the capital structure decision. Capital structure, therefore, is relevant. The concepts of modern finance or being adopted slowly into practice. However, they are still not fully accepted. Casual observation also shows that some people spend a great deal of time trying to pick the right numbers in lotteries. However, in most lotteries there is essentially no difference between tickets until after the drawing. Similarly, millions of investors spend enormous time trying to pick winning stocks, when most research reveals that virtually all of these investors are unable to succeed in consistently picking winning stocks. Similar arguments can be made with regard to palm reading, horoscopes, and so forth. The fact that thousands or millions of people think that they are useful does not validate their usefulness. Problem Respond to the following question: Almost all financial analysts view financial leverage as being an extremely important factor when they analyze a firm. How can it be irrelevant? As discussed in the answer to discussion question #2, there is no doubt that leverage will affect the financial results "after the fact". Thus, it can be very important to a creditor whether or not a firm is highly levered since the amount of leverage helps reveal the amount of risk being borne by the debt holders. However, this does not prove that one capital structure will create higher equity values at the present or current time. Financial Leverage 2 Discussion and Review Questions
3 Financial Leverage Review Questions 5th Edition Chapter 13 Problem Describe the "capital structure" decision of the firm. The capital structure decision is the decision of where to obtain the money to finance assets. The capital structure decision is known also as the financing decision and the debt to equity decision. Large firms typically choose to finance their assets with many different types of securities, falling into the main categories of debt securities and equity securities. Problem How do traditionalists view the firm's capital structure decision? Traditionalists believe that the financing decision is very important and that the firm should search for the package of securities which minimizes the aggregate cost of obtaining capital for the firm. In the traditionalists position, the firm's cost of capital changes according to the firm's mix of debt and equity securities. Given that the cost of capital is used to determine the overall value of the firm, traditionalists believe that firm value can be maximized at some optimum level of debt financing. Problem How do modernists view the firm's capital structure decision? Modernists claim that, in perfect markets, the firm's choice of financing package is irrelevant. This is to say that modernists believe that there is no ideal or optimal capital structure. Modernists believe that corporate managers can do far more to maximize shareholder wealth by properly managing the firm's assets rather than by transacting in financial markets. Problem What is financial leverage? Financial leverage is the use of debt to change the risk of the firm's equity. At very low levels of debt, debt usage has little effect on the claims of the debtholders but serves to increase the risk of the claims to the equityholders. However, at high levels of debt usage, the limited liability of equityholders acts to transfer some of the increased risk to the debtholders. The key result however is that the risk of the firm is determined not by how the assets are financed but by the risk of those assets. Thus, the only way to change the total risk of the firm is to change the assets. Financial leverage will not change total risk - it will only partition the risk between debtholders and equityholders. Problem Why is the equity of the firm also known as residual claims? Financial Leverage 3 Discussion and Review Questions
4 Problem 6. Equity represents a residual claim because equityholders receive only the cash flow that remains after all other firm claimants (debtbolders, governments, workers) have been paid. The notion of residual claims become clear when discussing the capital structure decision of the firm because the decision to take on debt increases the amount of claims on the cash flows of the firm that must be paid first, in this case to debtholders. 6. Why does the presence of debt change the risk of holding equity in a firm? Because equity represents a residual claim, the risk to equityholders become greater with leverage because debt represents prior claims on the cash flows of the firm. The risk is born entirely by the equityholders at low levels of debt, but begins to be shifted to debtholders at higher levels of debt. Problem Explain the term debt capacity as it relates to the traditionalists' view of capital structure. The traditionalist position is that there exists an optimal capital structure. Thus, under the traditionalists' arguments, one of the goals of corporate management is to tinker with the use of debt to find the range of debt that minimizes the firm's cost of capital and maximizes firm value. The optimal level of debt is known as the debt capacity. Problem What is the modernists'-or the M&M-position on the capital structure decision in perfect markets? Modernists' believe that under ideal conditions, an capital structures produce the same total cost of capital to the firm and the same total firm value. Said differently, modernists believe that the financing decision is irrelevant. Problem What is short selling? What direction of prices (up or down) would benefit the short seller? Short selling is an investment technique that seeks to take advantage of expected decreases in stock prices. You short sell by first selling a security you do not own to another investor at the Current price. Short sellers promise to buy the security back at a later date and hopefully at a lower price. The difference between the selling price and the buying price represents the gain or loss to the short seller. Problem Explain what homemade leverage is, and how modernists use homemade leverage in their arguments. Homemade leverage is the creation of financial leverage at the individual investor level. Under the ideal conditions of a perfect market, an investor can dismantle or replicate any leverage Financial Leverage 4 Discussion and Review Questions
5 decision of the firm. For example, an investor can combine the investment in an unlevered firm with borrowing on her own account and create the cash flow stream of a levered firm. Homemade leverage represents a compelling argument that there exists little or no advantage to having leverage decisions made at the corporate level in a perfect market. Financial Leverage 5 Discussion and Review Questions
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