Corporate financeLesson 3 of 3 in the course How Firms Raise Capital

Capital Structure, Leverage, WACC, and Interest Tax Shields

5 flashcards · 5 quiz questions · 5 match pairs · 5 fill-in sentences · English

Save course
Lesson progress
0 / 5

Your progress is kept in this browser only.Sign up to save it

Summary

Capital structure describes how a firm finances its assets, especially through debt and equity. This lesson introduces the basic financing choices and uses a T-shirt business to show how an all-equity, or unlevered, firm is valued.

The mix of financing sources is the firm’s capital structure. A firm financed only with equity has no debt and therefore no financial leverage. Its equity is called unlevered equity.

All flashcards

What is capital structure?
The mix of financing sources, particularly debt and equity, that a firm uses to fund its assets and activities.
What does MM Proposition I state in perfect capital markets without taxes?
A firm's total value is unchanged by its financing mix: VL=VUV_L = V_U.
What is a residual claimant?
An equity holder who receives what remains after prior claims, such as debt payments, are met.
How does MM Proposition II relate leverage to the cost of equity?
In the no-tax perfect-market setting, the cost of equity rises with the debt-to-equity ratio.
What is the interest tax shield?
The corporate tax saving from deductible interest, equal to the tax rate times interest payments.

Quiz questions

  1. A firm owes $17,680 to debt holders at year-end and generates $52,000 in cash flow. How much remains for shareholders?Answer: $34,320.
  2. Under MM Proposition I, with perfect capital markets and no taxes, what happens to total firm value when a firm changes its debt-equity mix?Answer: Total firm value remains unchanged.
  3. A firm has debt of $17,000 and equity of $28,614. Their required returns are 4% and 19.94%, respectively. What is the approximate no-tax WACC?Answer: 14%.
  4. In the no-tax perfect-market setting of MM Proposition II, what happens to the required return on equity as the debt-to-equity ratio increases?Answer: It increases to compensate for greater equity risk.
  5. When interest is deductible and a firm can use the deduction, how does debt affect firm value relative to an otherwise identical unlevered firm?Answer: The interest tax shield can increase the levered firm's value.

Based on Principles of Finance by Julie Dahlquist, Rainford Knight (OpenStax), licensed CC BY 4.0. Adapted into a summary, flashcards and quizzes.

More in Corporate finance

All Corporate finance lessons
Corporate financeCapital Structure: Debt, Equity, and Market-Value Weights5 flashcards · 5 quiz questions · 4 gamesPlay free →Corporate financeWACC Estimation: Capital Weights, Equity Costs, and Net Debt5 flashcards · 5 quiz questions · 4 gamesPlay free →Corporate financeCapital Budgeting: Project Comparisons, Capital Constraints, and Uncertainty5 flashcards · 5 quiz questions · 4 gamesPlay free →Corporate financeProject Evaluation: Profitability Index, Discounted Payback, and MIRR5 flashcards · 5 quiz questions · 4 gamesPlay free →