Perfect Markets Chapter 14
assume beta of debt is always
0
if theres no debt , what would be the debt to equity ratio?
0
Leveraged recapitalization
When a firm uses borrowed funds to pay a large special dividend or repurchase a significant amount of outstanding shares
conservation of value principle
With perfect capital markets, financial transactions neither add nor destroy value, but instead represent a repackaging of risk (and therefore return).
unlevered firm
all equity no debt
dilution
an increase in the total number of shares that will divide a fixed amount of earnings
D + E
assets
Re (WACC)
cost of equity (required rate of return)
Re (Proposition ll formula)
cost of levered equity
Ra (Propsition ll formula)
cost of unlevered equity
if you are given debt to asset (D/A) convert it to
debt to equity
if debt to asset is given what do you convert it to ?
debt to equity (D+E =A)
D/E
debt to equity ratio
WACC is an average, will always be between cost of ___ & cost of ___
debt, equity
cost equity ____ as leverage goes down
decreases
What are securities most commonly used by firms?
equity and debt
levered equity
equity in a firm with outstanding debt
rm-rf
equity risk premium
a risk free loan must carry risk free rate because
everybody is paid before shareholders (they take the most risk), bank takes no risk, stockholders are the residual claimants to the firm
Modigliani and Miller Proposition I
firm's financing choice does not affect its value
agressive beta
greater than 1
high volatility
high risk
cost of equity ___ as leverage goes up
increases
if cash flows increase, market value of a company ______
increases
Arbitrage
investor buys and sells an asset in different markets to generate profit
debit is ___ risky than equity
less (lower cost of capital)
is unlevered equity or levered equity riskier?
levered equity
if the risk of debt is higher, then the risk of the equity must be ______
lower (the debt will share some of the risk)
for debt and equity ___ value must be used
market (NEVER use book)
rm
market return
A
market value of firms assets
D (WACC)
market value of the firm's debt
E (WACC)
market value of the firm's equity
capital markets are perfect if they satisfy what conditions?
no taxes, no transaction costs, perfect information
perfect information
not knowing what exactly will happen, but agreeing what cash flow will occur if something else happens
PV of a perpetuity is located
one period (n) before the first payment (m)
PA
per year
A positive NPV means
project is expected to add value
stockholders are the ____ _____ to the cash flows of the firm, they get last dibs ALWAYS
residual claimants
Rd
return on debt
Ru
return on unlevered equity
debt is cheap, but increases
risk and cost of capital of the firm's equity
rf
risk free rate
risk free loans must carry a
risk free rate
The firm's capital structure refers to:
the collection of securities a firm issues to raise capital from investors
Modigliani and Miller proposition ll
the cost of capital of levered equity increases with the firm's market value debt-equity ratio
Capital Structure
the relative proportions of debt, equity, and other securities that a firm has outstanding
risk premium
the return over and above the risk-free rate
if you are given Re what formula do use to solve for Ra??
the wacc (NOT prop ll)
if the cash flows of a project do not change, the ____ of the project does not change
value
VL
value of levered firm
VU
value of unlevered firm
Leverage increases the (2)
volatility of earnings per share and riskiness of its equity
WACC
weighted average cost of capital
homemade leverage
when investors use leverage in their own portfolios to adjust the leverage choice made by a firm