13_Chapter 16_Capital_Structure.pptx - Chapter 16 Capital...

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Chapter 16 Capital Structure
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Does the capital structure of a firm affect a firm’s value? What is value? Market not book value! Price investors are willing to buy and sell the claims on the assets of the firm Value is a function of: Expected future cash flows; and The discount rate A higher discount rate implies a lower value To assess the effect of valuations on capital structure we: Hold the expected cash flows constant Analyze the effect of changes in capital structure on value
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Recall from Ch. 13 that the value of the firm is the net present value of its cash flows 3 1 0 3 2 2 1 (1 ) (1 ) (1 ) T T T WACC WACC WACC WACC CF CF CF CF TV V R R R R L
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What does WACC tell us about the optimal debt and equity levels? If we can lower WACC then we increase the NPV of the firm’s cash flows. Lowering WACC is equivalent to increasing the value of the firm. This is analogous to why the traded price of bonds is negatively related to the rate of interest. Rate increase implies bond price decreases Rate decrease implies bond price increases
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To analyze the optimal capital structure we: Start with strict assumptions Gradually relax the assumptions Propositions – Without and With Taxes Modigliani and Miller (MM I -- Valuation) Modigliani and Miller (MM II – Cost of capital) Implications for firm valuation Implications for the cost of capital Implications for CAPM
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Assumptions No Taxes Frictionless Capital Markets: No flotation costs, trading costs. Individuals and corporations can borrow and lend at the risk free rate No bankruptcy costs Two types of claims Riskless Debt Risky Equity Cash streams are perpetuities No information asymmetries Managers maximize shareholder wealth (no moral hazard) Operating Cash Flows are not affected by changes in Capital Structure
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MM I (no taxes) – The value of the firm is not affected by leverage Value = Bond + Stock = B + S Two equivalent firms Firm A – All equity financed Firm B – Equity and Debt financed Homemade leverage Own Firm A Borrow to exactly match capital structure of Firm B Cash flows of A plus borrowing exactly match equivalent levered firm Law of One Price Investor pays the same price for identical stream of cash flows Homemade leverage allows an investor to exactly re-create the stream of cash flows What would a hedge fund do if this relationship was violated? Implications Value of a levered firm equals an unlevered firm Capital structure is irrelevant
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Example for MM I Trans arm Corporation : Current All equity financed (100% Equity).
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  • Spring '18
  • e dfg erg
  • Net Present Value, Modigliani-Miller theorem, Weighted average cost of capital

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