Lecture 5: Perfect Capital Market

Levered equity

Equity in a firm that also has debt outstanding.

Unlevered equity

Equity in a firm with no debt.

Modigliani and Miller I

In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.

Perfect Capital Market

Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows. There are no taxes, transaction costs, or issuance costs associated with security trading. A firm's financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them.

Modigliani and Miller LofOP

The Law of One Price implies that leverage will not affect the total value of the firm. Instead it merely changes the allocation of cash flows between debt and equity, without altering the total cash flows of the firm.

Modigliani and Miller II

The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the market value debt-equity ratio.

Capital structure

The relative proportions of debt, equity, and other securities that a firm has outstanding.

Modigliani and Miller

With PCMs, the total value of a firm should not depend on the capital structure. The firm's total cash flows still equal the cash flows of the project and therefore have the same present value.