Chapter 14 (Finance)

the cost of capital for this projects 15%, because the expected cash flow in one year is

1/2 (1400) + 1/2(900) = 1150 (the 1400 was the strong economy and the 900 was the weak economy) NPV = -800 + 1150/1.15 = -800+ 1000 = 200

Any fain or loss associated with the transaction will result from the

NPV of the investments in the firm makes with the funds raised

Leverage can increase a firm's

expected earnings per share

With perfect capital markets, the firm's weighted average cost of capital, and therefore the NPV of the expansion, is

unaffected by how EBS chooses to finance the new investment.

Equity in a firm with no debt is called

unlettered equity

Perfect Capital Markets:

1/Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows. 2. There are no taxes, transaction costs, or issuance costs associated with security trading. 3. A firm's financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them

Debt to value ratio

D/(E + D), which is the fraction of the firm's total value that corresponds to debt. With no debt, the WACC is equal to the unlevered equity cost of capital.

The collection of securities a firm issues to raise capital from investors is called the firm's capital structure.

Equity and debt are the securities most commonly used by firms. When equity is used without debt, the firm is said to be unlevered. Otherwise, the amount of debt determines the firm's leverage

The market value balance sheet captures the idea that value is created by a firm's choice of assets and investments. By choosing positive-NPV projects that are worth more than their initial investment, the firm can enhance its value. Holding fixed the cash flows gener-ated by the firm's assets, however, the choice of capital structure does not change the value of the firm. Instead, it merely divides the value of the firm into different securities.

Market value of equity = market value of assets - market value of debt and other liabilities

MM Proposition 1 that as long as the securities are fairly priced, these financial transactions have an

NPV of zero and offer no benefit to shareholders

Equity in a firm that also has debt outstanding is called levered equity.

Promised payments to debt holders must be made before any payments to equity holders are distributed

The conservation ova Lue principle for financial markets:

With perfect capital markets, financial transactions neither add nor destroy value, but instead represent a repackaging ofrisk (and therefore return). The conservation of value principle extends far beyond questions of debt versus equity or even capital structure. It implies that any financial transaction that appears to be a good deal in terms of adding value either is too good to be true or is exploiting some type of market imperfection.

The amount of additional risk depends on the

amount of leverage, measured by the firm's market clause debt equity ratios

The assets on a firm's balance sheet include

any holdings of cash or risk free securities

Recall that the unlevered beta measures the market risk of the firm's underlying assets, and thus can be used to

assess the cost of capital for comparable investments. When a firm changes its capital structure without changing its investments, its unlevered beta will remain unaltered.

Investors can alter the leverage choice of the firm to suit their personal tastes either by

borrowing and adding more leverage or by holding bonds and re-ducing leverage.

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

capital structure.

We can evaluate the relationship between risk and return more formally by

computing the sensitivity of each security's return to the systematic risk of the economy

we can calculate the enterprise value of the firm by

discounting its future free cash flow using the WACC.

We can use Modigliani and Miller's first proposition to derive an

explicit relationship between leverage and the equity cost of capital.

When corporations raise funds from outside investors, they must choose which type of security to issue. The most common choices are

financing through equity alone and financing through a combination of debt and equity.

Investors in levered equity require a

higher expected return to compensate for its increased risk

When investors use leverage in their own portfolios to adjust the leverage choice made by the firm, we say that they are using

homemade leverage. As long as investors can borrow or lend at the same interest rate as the firm,3 homemade leverage is a perfect substitute for the use of leverage by the firm.

If this project is financed using equity alone, how much would investors be willing to pay for the firm's shares?

in the absence of arbitrage, the price of a security equals the present value of its cash flows. Because the firm has no other liabilities, equity holders will receive all of the cash flows generated by the project on date 1. Hence, the market value of the firm's equity today will be PV(equity cash flows) = $1150 1.15 = $1000 So, the entrepreneur can raise $1000 by selling the equity in the firm. After paying the investment cost of $800, the entrepreneur can keep the remaining $200—the project's NPV—as a profit.

Perfect Capital markets

in which all securities are fairly priced, there are no taxes or transaction costs, and the total cash flows of the firm's projects are not affected by how the firm finances them

A market value balance sheet

is similar to an accounting bal-ance sheet, with two important distinctions. First, all assets and liabilities of the firm are included—even intangible assets such as reputation, brand name, or human capital that are missing from a standard accounting balance sheet. Second, all values are current market val-ues rather than historical costs.

firm can change its capital structure at any time by

issuing new securities and using the funds to pay its existing investors

with perfect capital markets, a firm's WACC is independent ofits capital structure and is equal to

its equity cost ofcapital ifit is unlevered, which matches the cost ofcapital ofits ass

Harrison Industries is currently an all-equity firm operating in a perfect capital market, with 50 million shares outstanding that are trading for $4 per share. Harrison plans to increase its leverage by borrowing $80 million and using the funds to repurchase 20 million of its outstanding shares. When a firm repurchases a significant percentage of its outstanding shares in this way, the transaction is called a

leveraged recapitalization.

Because the project cash flows depend on the overall economy, they contain

market risk

MM Propositions I and II state that with perfect capital markets, leverage has

no effect on firm value or the firm's overall cost of capital.

leverage increases the risk of equity even when there is

no risk that the firm will default.

If a firm is financed with both equity and debt, then the risk of its underlying assets will match the

risk of a portfolio of its equity and debt

Proposition I was one of the first arguments to show that the Law of One Price has

strong implications for secu-rity prices and firm values in a competitive market; it marks the beginning of the modern theory of corporate finance.

Another often-heard fallacy is that issuing equity will dilute existing shareholders' own-ership, so debt financing should be used instead. By dilution, the proponents of this fallacy mean that if the firm issues new shares, the cash flows generated by the firm must be divided among a larger number of shares, thereby reducing the value of each individual share. The problem with this line of reasoning is

that it ignores the fact that the cash raised by issuing new shares will increase the firm's assets.

With perfect capital markets, the Law of One Price implies

that the choice of debt or equity financing will not affect the total value of a firm, its share price, or its cost of capital. Thus, in a perfect world, EBS will be indifferent regarding the choice of financing for its expansion.

MM Proposition II: The cost of capital of levered equity increases with

the firm's market value debt-equity ratio

MM Proposition I: In a perfect capital market, the total value of a firm's securities 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.

MM Proposition I: Although debt has a lower cost of capital than equity, leverage does not lower a firm's WACC. As a result,

the value of the firm's free cash flow evaluated using the WACC does not change, and so the enterprise value of the firm does not depend on its financing choices

In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firm's security holders is equal to the

total cash flow generated by the firm's assets. Therefore, by the Law of One Price, the firm's securities and its assets must have the same total market value

The market value balance sheet shows that the total market value of a firm's assets equals the

total market value of the firm's liabilities, including all securities issued to investors.

Capital markets are said to be perfect if they satisfy three conditions:

■ 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