Chapter 14 - Capital Structure: Basic Concepts

Corporation gains no value from an interest tax shield if:

- corporation has no debt - corporation is an all-equity firm - corporate tax rates are zero

Value of firm is the same with debt/equity financing because...

- debt financing and equity financing are not better than the other - the asset to be financed is the same

Various equations

- present value of tax shield - value of the levered firm - MM proposition I - expected return and leverage under corporate taxes

Steps to calculate the value of levered firm with perpetual cash flowers

1. Calculate EBIT 2. Multiple EBIT by 1 minus the corporate tax rate 3. Divide the cost of equity for an all-equity firm 4. Add the present value of the debt tax shield

A corporation gains no value from an interest tax shield if:

1. The corporation has no debt 2. The corporation is an all-equity firm 3. Corporate tax rates are zero

An individual can duplicate a levered firm through a strategy called _____ where the investor uses his own funds plus borrowed funds to buy stock

Homemade leverage

Something good to note

Levered firm (includes debt) pays less in taxes than does the all-equity firm

Modigliani and Mill Prop. II

No Taxes As expected return rises with leverage, the risk rises as well

MM Proposition II (no taxes) equation

Rs = R0 + B/S (R0-RB) Required return on equity is a linear function of the firm's debt-to-equity ratio Rs - cost of equity Rb - cost of debt R0 - cost of capital for all equity firm Rwacc - firm's weighted avg cost of capital. World with no taxes, this value should equal R0 R0 should exceed RB because even unlevered equity is risky, it should have an expected return greater than that of riskless debt

MMI Homemade leverage

The substitution of... If levered firms are priced too high, rational investors will simply borrow on their personal accounts to buy shares in unlevered firms.

Define V = B + S

V = value of the firm B = market value of the debt S = market value of the equity

Levered

after the issuance of debt Leverage also created risk

MMII

argue that the expected return on equity is positively related to leverage, because the risk to equity-holders increases with leverage

When calculating the cash flow for a levered firm, you must consider

cash flows to both bondholders and stockholders

Unlevered company

company with no debt

Market value balance sheet differs from accounting because

does not use historical values

cost of capital (%)

expected earnings after interest / equity

MM Proposition II implies that

expected rate of return on equity (aka cost of equity, required return on equity) is positively related to the firm's leverage risk of equity rises with leverage

T/F: holding equity in an unlevered firm has no risk

false

MMI key assumption

individuals can borrow as cheaply as corporations

Rwacc weighted average cost of capital

know equation probably

Market value balance sheet

left - liabilities right - debt, equity same idea, but with market value numbers

MMI, value of levered firm is the same value of an all equity firm

plus the tax rate times the value of debt

Rs = R0 + B/S (R0-RB) Firm's cost of equity capital (R0) exceed cost of debt, than it is _____ related to firm's debt/equity ratio

positively

Under MM Proposition II, a firm's cost of equity capital is ____ related to the firm's debt-to-equity ratio provided the cost of capital for an all-equity firm exceeds the cost of debt

positively

The expected return on equity is ______ to leverage

positively related

Under MMII with no taxes, WACC is invariant to the debt-equity ratio because _____

return on assets (R0) is unchanged

MMII proposition shows that

the cost of equity rises with leverage

MM interpretation

- indicates that managers cannot change the value of a firm by repackaging the firm's securities - argues that firm's overall cost of capital is not reduced when debt is substituted for equity. Although debt appears to be cheaper than equity, as debt increases the risk of the existing equity goes up. MM prove that the two effects (increase of debt to equity ratio, cost of remaining equity) exactly offset each other cost of capital is invariant to leverage

True statements regarding the effect of financial leverage and the firms operation earnings (EBI)

- rate of return on assets is unaffected by leverage - below the indifference or break-even point in EBIT, an unlevered capital structure is best - financial leverage increased the slope of the EPS line

Buyers who sell stock on margin will protect themselves by

- selling the stock to satisfy the loan - requiring additional cash contributions from the investor - holding the stock as collateral

In the absence of taxes, the MM propositions state

- the stock price is unaffected by a firm's capital structure - the debt-equity ratio does not affect the value of a firm

Three aspects of MM

1. Value of the firm does not change with debt/equity financing 2. Stock prices don't change 3. Expected return to equityholders rise as leverage increases

MMI - Stock exchange rules regarding individuals and broker relationship

Broker fears that a sudden price drop will cause the individual's account to be negative and unable to pay back. Soooo... individual must make additional cash contributions as the stock price falls Brokers generally charge low interest, with many rates being only slightly the risk-free rate

MM Proposition I

Convincing argument that a firm cannot change the total value of its outstanding securities by changing the proportions of its capital structure. The value of the firm is always the same under different capital structures. No capital structure is any better or worse than any other capital structure for the firm's stockholders.

Pie-model is used to define which ratio?

Debt-equity Whole pie is the sum of the financial claims of the firm, debt, and equity. Firm should pick the debt-equity ratio that makes the pie - the total value - as big as possible