Intermediate FinanceLecture 3: Capital Structure 1 (No Taxes)Michael HaslerDepartment of Management UTSC0 / 30

Capital StructureDefinitionThe capital structure of a firm is the firm’s choice of the financingsourcesIn other words, the capital structure of a firm tells you how a firmfinances its projects1 / 30

Capital Structure across CountriesThe debt ratio is the ratio of the book value of debt to the sum ofthe book value of debt and market value of equity2 / 30

Capital Structure across Industries3 / 30

Capital Structure in same IndustrySource: Berk & DeMarzo, May 20084 / 30

QuestionsWhat is the optimal capital structure? Optimal choice of leverage?Does leverage affect firm value?Can you create shareholder value by changing leverage?Does expected return on equity increase with leverage?Does the equity Beta increase with leverage?5 / 30

Capital Structure6 / 30

Capital StructureAssets:IA is the market value of assetsIrAis the expected return on assetsSecuritiesIS (resp. B) is the market value of equity/stocks (resp. bonds)IrS(resp.rB) is the expected return on equity, called “cost of equity”(resp. “cost of debt”)Unlevered firm:S0andr0denote the value of equity and the cost ofequity in an unlevered firm7 / 30

Capital Structure without FrictionsModigliani-Miller 1 (MM1): ExampleTwo firmsuandlhold assets that generate the same earnings everyyear and forever before interests are paidStateEarnings before interestsRecession30,000Normal80,000Boom120,000Both firms have 100 stocks outstandingFirmuis unlevered (no debt)Firmlhas a perpetual debt with face value 500,000. The annualcoupon rate is 5% paid once a year and the risk free rate is 4%8 / 30

Capital Structure without FrictionsMM1: ExampleAssumptions made:No FrictionsICapital structure doesn’t affect the operational performanceINo arbitrage opportunitiesINo taxesINo default risk (debt is risk free)How do the firm values ofuandlcompare with each other?9 / 30

Capital Structure without FrictionsMM1: ExampleValue of firmuStateEarnings before interestsEarnings=Net Incomeper Share (EPS)Recession30,000300Normal80,000800Boom120,0001,200The value of the unlevered firm isAu=S0=ÿYears100◊E(EPS) discounted=100ÿYearsEQca3008001,200Rdbdiscounted10 / 30

Capital Structure without FrictionsMM1: ExampleValue of firmlStateEarnings

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- SyedAhmed
- Modigliani-Miller theorem, Weighted average cost of capital