IFM9 Ch 16 Show

IFM9 Ch 16 Show - Chapter 16 Capital Structure Decisions:...

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  1 Chapter 16 Capital Structure Decisions: Part II
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  2 Topics in Chapter MM and Miller models  Hamada’s equation Financial distress and agency costs Trade-off models Asymmetric information theory
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  3 Who are Modigliani and Miller  (MM)? They published theoretical papers that  changed the way people thought about  financial leverage. They won Nobel prizes in economics because  of their work. MM’s papers were published in 1958 and  1963.  Miller had a separate paper in 1977.   The papers differed in their assumptions  about taxes.
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  4 What assumptions underlie  the MM and Miller Models? Firms can be grouped into  homogeneous classes based on  business risk. Investors have identical expectations  about firms’ future earnings. There are no transactions costs. (More. ..)
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  5 All debt is riskless, and both individuals  and corporations can borrow unlimited  amounts of money at the risk-free rate. All cash flows are perpetuities.  This  implies perpetual debt is issued, firms  have zero growth, and expected EBIT is  constant over time. (More. ..)
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  6 MM’s first paper (1958) assumed zero  taxes.   Later papers added taxes. No agency or financial distress costs. These assumptions were necessary for  MM to prove their propositions on the  basis of investor arbitrage.
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  7 Proposition I: V L = V U . Proposition II: r sL = r sU + (r sU - r d )(D/S). MM with Zero Taxes (1958)
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  8 Given the following data, find V, S, r s and WACC for Firms U and L. Firms U and L are in same risk class. EBITU,L = $500,000. Firm U has no debt; r sU  = 14%. Firm L has $1,000,000 debt at r d  = 8%. The basic MM assumptions hold. There are no corporate or personal  taxes.
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  9 V U = = = $3,571,429. V L = V U = $3,571,429. EBIT r sU $500,000 0.14 1. Find V U  and V L .
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  10 V L = D + S = $3,571,429 $3,571,429 = $1,000,000 + S S = $2,571,429. 2. Find the market value of  Firm L’s debt and equity.
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  11 r sL = r sU + (r sU - r d )(D/S) = 14.0% + (14.0% - 8.0%) ( ) = 14.0% + 2.33% = 16.33%. $1,000,000 $2,571,429 3. Find r sL .
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  12 WACC = w d r d + w ce r s = (D/V)r d + (S/V)r s = ( ) (8.0%) + ( ) (16.33%) = 2.24% + 11.76% = 14.00%. $1,000,000 $3,571,429 $2,571,429 $3,571,429 4. Proposition I implies WACC = r sU .     Verify for L using WACC formula.
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  13 Without taxes Cost of Capital (%) 26 20 14 8 0 20 40 60 80 100 Debt/Value Ratio (%) r s WACC r d MM Relationships Between Capital Costs  and Leverage (D/V)
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14 The more debt the firm adds to its  capital structure, the riskier the equity  becomes and thus the higher its cost. Although rd remains constant, r
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This note was uploaded on 04/12/2008 for the course BUS 420 taught by Professor Poindexter during the Spring '08 term at N.C. State.

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IFM9 Ch 16 Show - Chapter 16 Capital Structure Decisions:...

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