Capital Structure

Modigliani Miller Proposition 2

-Condition of no taxes -The cost of equity is a linear function of the company's debt/equity ratio -cost of equity increases to offset the increased use of cheaper debt to maintain a constant WACC and thus constant MV of the company -as level of debt rises, risk of company default rises and this cost is borne by the equity holders -can also think of WACC as the asset beta, where cost of equity is equity beta and cost of debt is debt beta C(equity) = WACC + [WACC - C(debt)](D/E)

Effect of Taxes

-because interest paid is tax deductible, the use of debt provides a tax shield that translates into saving that enhance the value of a company -value of company increases with increasing levels of debt -by making interest costs tax deductible, government is effectively subsidizing companies' us of debt

Optimal Capital Structure (Static Trade off theory)

-capital structure where value of company is maximized -results in optimal capital structure where debt is less than 100% a company's capital structure -balances the expected costs of financial distress against tax benefits of debt payments Levered Value = Unlevered value + tD - PV(costs of financial distress)

Modigliani Miller Proposition 1

-condition of no taxes -The market value of a company is not affected by the capital structure of the company

Tax effect on MM Proposition 2

-cost of equity becomes greater as the company increases the amount of debt, but does not rise as fast as in the no-tax case -due to inclusion of (1-t)

Agency Costs

-costs associated with the fact that companies are run by non-owners, such as conflict of interests in decision-making -prerequisite consumption refers to items that executives make legally authorize such as subsidized dining, a corporate jet fleet, and more that are a cost to shareholders

Modigliani-Miller

-given certain assumptions, a company's choice of capital structure does not affect its value

Free Cash flow hypothesis

-higher debt levels discipline management by forcing them to manage the company efficiently in order to make interest and principal payments and by reducing the company's free cash flow and thus management's opportunity to misuse cash

Pecking Order Theory

-managers choose methods of financing with preference to methods with least potential information content (internal funds) -preference starting at internal financing, then debt, then equity (public) -also that management will issue equity when it is overvalued, a possible warning sign to investors

Capital Structure

-the mix of debt and equity that a company chooses to finance its business -goal to determine structure that maximizes the value of the company by minimizing the weighted average cost of Capital

Asymmetric Information

-unequal distribution of information arises from the fact that managers have more information about a company's performance and prospects than do outsiders such as owners and creditors

Modigliani Miller - Effect of tax shield

-value of company with debt is greater than that of the all-equity company by an amount equal to the tax rate multiplied by the value of debt -WACC for the company with debt must be lower than that for all-equity company -does not consider financial distress or bankruptcy costs -would mean that optimal capital structure is all debt Levered Value = Unlevered value + tD t=marginal tax rate D=market value of debt

weighted average cost of capital (WACC)

-weighted average of the marginal costs of financing for each type of financing used -D and E are the market values of the shareholder's debt and equity, respetively V= D + E

Factors affecting capital structure across countries

1) Institutional and legal environment: taxation, accounting, corruption 2) Financial markets and banking sector: access to financing 3) Macroeconomic environment: influence of economic growth and inflation on capital structure

Assumptions of Modigliani-Miller Theory

1) Investors have homogenous views on expected cash flows from a company/project 2) Bonds and shares of stock are traded in perfect capital markets 3) Investors can borrow and lend at the risk-free rate 4) There are no agency costs 5) The financing decision and investment decision are independent of each other

Components of Agency Costs

1) Monitoring costs: costs borne by owners to monitor expenses of management 2) Bonding costs: costs to assure that management is working in best interest of owners such as noncompete employment contracts and insurance to guarantee performance 3) Residual Loss: Costs that incurred even when there is sufficient monitoring and bonding

Expected Cost of Financial Distress

1) costs of financial distress and bankruptcy if they happen -companies with more liquid assets have a lower cost of financial distress 2) the probability that financial distress and bankruptcy will happen -increases as the degree of leverage increases

Actual cost of debt when including tax benefit

After-tax cost of debt = (before-tax cost of debt)*(1-marginal tax rate)