Answers from book

(a) A discussion of bond finance versus bank term loans should explain the following:
Advantages (any 2 of the list below):
Larger amounts can be raised from the capital markets than from individual banks.
Longer maturities are possible, with a variety of repayment arrangements, which enables
borrowers to match liabilities to fixed asset lives.
Bank covenants tend to be more onerous than bond covenants.
Large, creditworthy borrowers can obtain finance at more attractive rates than what a bank
could provide.
Borrowers can diversify funding away from bank lending sources and avoid being overdependent on the latter.
Disadvantages:
Bond financing involves issue costs that are absent in the case of term loans.
1) Relationships with individual banks are often valuable since they may offer a variety of
other banking facilities and may come to the borrowers assistance in times of trouble
this close relationship with the lender tends to be absent with bond financing.

(b) Dividend policy is actually a financing decision; to finance growth, a company may choose to
issue stock, allowing internally generated funds to be used to pay dividends, or may use the
internally generated funds to finance growth, paying less as dividends but not having to
issue new stock. Shareholders therefore either receive dividend income or capital gain. The
nature of the return may be different, but the total return should be the same.

Therefore the value of a company is unaffected by its dividend policy. A firms business is to
make positive NPV investments. When external financing is available in a perfect market,
dividend payment does not prevent the firm from making such investments, so dividend policy is
irrelevant.

This view is based on two assumptions:

Perfect capital markets (no transaction costs, no issue costs, no corporate taxes,
information is readily available, no agency problems, and financial distress is non existent).
This assumption allows us to study the effect of dividend policy in isolation.

Firms investment and borrowing decisions have been made and will not be altered by
dividend payment. This assumption allows us to consider dividend decisions on a standalone basis, without influencing or being influenced by other decisions.

a) Factors that influence dividend decisions in practice

Legal Restrictions: debt and preferred stock contracts may impose constraints on dividend
policy.
Liquidity Constraints: paying dividends require availability of cash not earnings.
Earnings Predictability: firms with stable and predictable earnings are more likely to pay
larger dividends.
Investment Opportunities: companies with high growth prospects prefer to retain profits to
sustain growth.
Maintaining control: companies that do not wish to dilute ownership would prefer to retain
profits for investment rather than raise fresh equity.
Agency Costs: shareholders may insist on high dividends to limit costs of leaving free cash
flow in managers hands.

M and M ANSWER 4
(a) According to this moderate position, the earning power of the firms assets would
increase to the extent of the tax shield on debt. The value of the levered firm (VL)
would therefore be equal to the value of the unlevered firm (VU) plus the present value
of the tax benefit of debt. The tax benefit of debt is the tax shield on debt interest, i.e.
rdxDebtxTc - where Tc is the corporation tax rate, rd is the interest rate on debt.
However, there will be a limit to the extent to which firm value can be increased in this
manner because of the following factors:

Bankruptcy costs: impact of tangible and intangible costs of financial distress

Agency costs: Agency costs of debt such as restrictive covenants increase with
leverage, and tend to limit the level of leverage that would be beneficial.
Borrowing capacity is limited by the nature and value of assets available as security.
Due to the tax benefit of debt, the weighted average cost of capital would normally come
down with leverage (instead of remaining unchanged as in Modigliani & Millers original
hypothesis). But as leverage increases, bankruptcy and agency costs will result in the cost
of equity increasing more and more sharply, and the cost of debt will also start increasing
this will result in the weighted average cost of capital starting to increase at higher levels
of leverage, resulting in a saucer-shaped weighted average cost of capital curve

1.5

1.5

1
5

1
Value of the firm under increasing levels of leverage:
1

VU

Firm value
Leverage (Debt Ratio)
2

1.5

1.5

1
8

3
12
25

ANSWER 5
(a) A business does not usually achieve its desired capital structure in one go for convenience
and cost minimisation, it tends to move towards the target structure by raising either debt or
equity in turn. The pool of capital raised in this manner is available to fund all the projects of
the business.
Using the cost of the latest capital raised (i.e. the marginal cost of capital) to discount the cash
flows of a project may therefore result in adverse selection of projects - it is more appropriate to
use the average cost of the total pool of funds, i.e. the weighted average cost of capital
(WACC).

RISK AND RETURN

a

The weighted average return is the same as the portfolio return calculated in
part (c).
But the weighted average standard deviation is higher than the portfolio
standard deviation of 6.98%. The reason for the portfolio standard deviation
being lower than the weighted average standard deviation is that some of the
risk is removed due to the two investments not being perfectly correlated.

The risk of an investment held in isolation is more than that of the same
investment held as part of a portfolio. This is because the risk of a portfolio will
be equal to the weighted average risk of the items in the portfolio only if there is
perfect positive correlation between the items if correlation is anything less
than perfectly positive the portfolio risk will be less than the weighted average
risk. Since perfect positive correlation between the components of a portfolio is
highly unlikely, portfolio diversification reduces risk. Combining investments in a
portfolio therefore results in reduction of overall risk. The maximum risk
reduction occurs when correlation is negative rather than positive.

P o rtf o lio R is k

D iv e rs i fi a b le ri s k

U n d iv e rs i fi a b le ri s k

N u m b e r o f S e c u r itie s

R IS K R E D U C T IO N T H R O U G H P O R T F O L IO D IV E R S IF IC A T IO N

As investments are added into a

portfolio, the risk of the portfolio, measured by its standard deviation, falls sharply.
But after the addition of about 15 to 20 investments to the portfolio, the risk
reduction effect begins to taper off:
There is therefore a portion of risk that cannot be diversified away this is called
non-diversifiable or systematic risk.