Chapter 15 - Capital structure decisions, Part 2

Chapter 15 - Capital structure decisions, Part 2 - Brigham...

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Brigham and Daves (2004) , Intermediate Financial Management Chapter 15 - Capital Structure decisions:Part 2 Capital structure theory, Arbitrage proofs of the MM models Assumptions Arbitrage – occurs if two similar assets (leveraged and unleveraged stocks) sell at different prices Arbitrageurs will buy the undervalued stock and simultaneously short the overvalued stock, earnings a profits, and this will continue until the prices of the two assets are equal Further assumptions o No taxes o Risk can be measured by the standard deviation of EBIT and firms are in homogeneous risk classes o Investors have homogenous expectations o Trading in perfect capital markets (no trading or information costs and borrowing of individuals and firms at the same rate) o Debt is riskless o All cash flows are perpetuities (→zero growth) MM without taxes Proposition 1 The value of any firm is established by capitalizing its expected EBIT at a constant rate Under the MM model, when there are no taxes, the value of the firm should be independent of the leverage o Since the WACC is completely independent of its capital structure o Regardless of the amount of debt the firm used, its WACC is equal to the cost of equity that it would have if it used no debt Proposition 2 When there are no taxes, the cost of equity to a levered firm is equal to the cost of equity to an unlevered firm in the same risk class plus a risk premium whose size depends on both the difference between an unlevered firm’s costs of debt and equity and the amount of debt used As debt increases, the cost of equity also rises and in a proportional manner Using more debt will not increase firm value since the benefits id cheaper debt will be exactly offset by an increase in the riskiness of equity Arbitrage
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Chapter 15 - Capital structure decisions, Part 2 - Brigham...

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