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Chapter 15 Capital Structure Basic Concepts

# Chapter 15 Capital Structure Basic Concepts - Chapter 15...

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EPS EBI, no tax Advantage to debt Debt Disadvantage to Debt Chapter 15 Capital Structure: Basic Concepts 15.1 The Capital-Structure Question and the Pie Theory V= B+S (B market value of debt; S market value of equity) Value of the firm is the sum of the financial claims of the firm, debt and equity The goal is to make the firm as valuable as possible→ pick the debt-to-equity method to maximise firm value 15.2. Maximizing Firm Value versus Maximizing Stockholders Interests Company with no debt → unlevered → after the issuance of debt it becomes levered Stockholders will be paid only after bondholders have been paid in full Changers in capital structure benefit stockholders if and only if value of firm increases Managers should choose capital structure that they believe will have highest firms value, because this capital structure will be most beneficial to firm’s stockholders 15.3 Financial Leverage and Firm Value: An Example For a all-equity firm ROA = ROE (Earnings after interest/Equity) ROA is calculated before interest Effect of financial leverage depends on earnings before interest For firm without leverage, EPS rises tandem with a rise in earnings before interest (EBI) For leveraged firm, EPS rise faster, line in EBI-EPS diagram is stepper, as there are fewer shares outstanding and a constant interest has to be paid on debt part of firm value Leverage is not only positive, but also created more risk for shareholder, as interest on debt has to be paid whatever earnings are The choice between Debt and Equity MM Proposition I (no taxes): The value of the levered firm is the same as the value of the unlevered firm. (r WACC constant) No capital structure is any better or worse than any other capital structure for firm’s stockholders → Firm cannot change total value of its outstanding securities by changing the proportions of its capital structure r wacc is constant regardless of the capital structure If levered firms are priced too high, rational investors will simply borrow on their personal accounts to buy shares in unlevered firms →Substitution called homemade leverage o As long as individuals borrow (and lend) on same terms as the firms, they can duplicate effects of corporate leverage on their own Key assumption → individuals borrow as cheaply as corporations o If individuals can only borrow at higher rate, corporations can increase firm value by borrowing 15.4 Modigliani and Miller: Proposition II (no taxes) Risk to Equity holders Rises with Leverage 1

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