Capital Structure - MM Theory (ppt)

Capital Structure - MM Theory (ppt) - Capital Structure...

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Click to edit Master subtitle style Capital Structure Theory Modigliani and Miller
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The Cost of Capital, Corporate Finance & The Theory of Investment 1. Capital markets are frictionless No transaction costs Securities infinitely divisible 2. Individuals can borrow & lend at the risk- free rate 3. There are no bankruptcy costs
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4. Firms issue only 2 types of claims: Risk – free debt Equity 5. There are no corporate or personal taxes 6. All cash flows are perpetuities (no growth) è New investment = Depreciation Consider an unlevered firm, i.e., no debt in its capital structure
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No Debt Firm Revenue - Variable Cost (VC) - Fixed Cost (FC) - Depreciation EBIT - Tc (EBIT) NI
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After – tax CF (before any capital expenditure) = EBIT – Tc(EBIT) + Depreciation Depreciation = New Investment (by assumption) è After – tax CF available for stockholders = EBIT – Tc(EBIT) + Depreciation – I = EBIT – Tc(EBIT) l Expected after – tax CF = EBIT(1-Tc) l Value of this perpetual CF or the value of an unlevered firm
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Vu = EBIT (1-T) (1) Ksu Where Ksu is the appropriate rate for unlevered firm = WACC Thus Ksu = WACC = EBIT (1-T) Vu (1) This equation defines the value of an unlevered firm
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Firms with Debt in Capital Structure Revenue - Variable Cost (VC) - Fixed Cost (FC) - Depreciation EBIT - Interest EBT - T(EBT) NI
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The CF available to stockholders and bondholders: NI + KdD = EBIT - KdD - Tc[EBIT - KdD] = EBIT(1-T) + Tc(KdD) Therefore, the expected CF: E(NI + KdD) = E(EBIT)(1-T) + T E(KdD) (2)
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The first part of equation 2 is exactly the same as the CF available to the unlevered firm, it should be discounted at the relevant discount rate Ksu The second part of the equation should be discounted at the rate used to discount debt payments i.e. they yield to maturity or the cost of debt Kd
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VL = EBIT (1-T) + T KdD Ksu Kd VU T D è VL = VU + T D
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The value of the levered firm is equal to the value of an unlevered firm (with the same asset structure) plus the PV of the tax shield provided by debt TD – gain from levered Arguably the most important result of the last 30 years
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In the absence of any market imperfections
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This note was uploaded on 12/07/2009 for the course FIRE 312 taught by Professor Salandro during the Spring '09 term at VCU.

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Capital Structure - MM Theory (ppt) - Capital Structure...

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