Notes #2 Capital Structure

Notes #2 Capital Structure - Professor Kose John NOTES ON...

Info icon This preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
Professor Kose John NOTES ON CAPITAL STRUCTURE These notes are meant to supplement Chapters 17 and 18 and part of Chapter 19 of our text book, Brealey and Myers, Seventh Edition. All references are to pages in our textbook. In the areas of financing decisions for a corporation there are many unresolved issues and active debates in the field. Even in a basic course it is hard to avoid them. So it is very important to examine the area in a systematic order of difficulty. I. Perfect Capital Markets - No Taxes II. Introduce Corporate Taxes III. Frictional Costs of Bankruptcy IV. Capital Structure with Corporate Taxes I. Perfect Capital Markets/No Taxes : The main results in this section are the famous MM theorems derived under assumptions of perfect capital markets and a tax-free economy (see section 17-1). Their Proposition I states that a firm cannot change the total value of its securities just by splitting its cash flows into different streams: the firm's value is determined by its real assets not by the securities it issues. Thus capital structure is irrelevant as long as the firm's investment decisions are taken as given. A simple proof is given on pgs. 467-468. 1
Image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Some key points to note: given an asset or a set of assets, which constitute the firm, the required rate of return r A from the asset is not affected by borrowing decisions of the firm. Its expected return (= required return) is determined by A the beta of the assets via the security market line. The required return on equity can be determined from the following equations (1) E D A r E D E r E D D r (2) D A A E r r E D r r The above equation summarizes Proposition II of MM (see pg. 473 of BM). Again given the asset of the firm A the beta of the assets is not affected by the borrowing decisions but E the beta of equity will be, according to: (3) A = E E D E E D D D (4) E = A + D A E D This clarifies why the investors require higher returns on levered equity.
Image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern