Lecture16 - TOPIC 16 CAPITAL STRUCTURE PART 1 Reading:...

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168 T OPIC 16 C APITAL S TRUCTURE P ART 1 Reading: Chapter 15 Practice Questions: see the word document on the website Objectives: Understand what Financing Policy entails Know how to use the M&M Theorem to focus financing issues Be able to debunk the WACC fallacy Understand the difference between financial distress and economic distress Understand the basics of bankruptcy Understand the tradeoff between the tax benefit of debt and expected costs financial distress Understand the debt-overhang problem and its implications for debt policy
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169 FINANCING POLICY (CAPITAL STRUCTURE): Up until now we have focused on the investment decisions of a financial manager. We will now concern ourselves with the Financing Decisions. That is, where do we get the cash to make the necessary investment? These questions are usually asked in the context of capital structure. Should the firm use equity or debt to finance its projects. This is determined by the fundamental question of how much total debt the firm should issue. Recent research confirms that firms have long-term target debt/equity ratios and they choose their financing so as to move them toward their target So if a firm is below its debt/equity ratio, it’s more likely to finance a project or acquisition with debt
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170 The Modigliani and Miller Theorem is where we start. M&M THEOREM 1. Assume: a) No Taxes b) No Transactions/Information Costs c) Fixed Operations* d) Fixed Real Investment Policy ** 2. Then The market value of the firm (i.e. the sum of all claims against it, including debt) is independent of the choice of financing policy (i.e., there is no unique capital structure that maximizes firm value.) * Fixed Operations means the firm operates the same way regardless of how it is financed; i.e. how it’s financed doesn’t change management’s incentives to cut costs, managegment’s ability to steal or waste money, relationships with customers or suppliers, etc. ** Fixed Investment Policy means that the firm will always make the same investments regardless of how it is financed.
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171 Proof Can be done with a no-arbitrage argument (Modigliani and Miller, American Economic Review, 1958) A discounted cashflow argument is more intuitve: With an all-equity firm, the value is: 1 [] (1 ) a A t t t V EC r = = + Now if we add debt, the value of equity is: 1 ) ) t ad E t tt t V EP rr = = ++ Where P t are debt service payments. The value of debt is: 1 1 t t d D t r V ⎛⎞ ⎜⎟ ⎝⎠ = + = V D + V E = V A QED There’s also the Pizza Pie proof: Investment policy and operations fix the size of the pie. No taxes or transactions cost means none of the pizza is lost in slicing.
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Lecture16 - TOPIC 16 CAPITAL STRUCTURE PART 1 Reading:...

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