FinanceFinalFormulaSheet - Book value of a firms stock can...

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MMI: * Value of unlevered firm = value of levered firm * One capital structure is as good as another * Leverage does not affect value of firm * Capital structure changes do not affect stockholders welfare * Does not hold in presence of taxes b/c levered firms pay less taxes compared to unlevered firms. * Stock price of firm does not vary with amount of debt since # of shares is reduced as debt increases. MMI with taxes: * Capital structure affects firm value * By raising debt-to-equity ratio, firm can lower its taxes and increase value * Firm value is maximized at an all debt capital structure MMII: * Expected return on equity is positively related to leverage * Required return on equity is a linear function of the firms debt-to-equity ratio * Risk to equity increases with leverage * Use of firm’s overall WACC to select investments is theoretically acceptable when systemic risk of projects are equal to systemic risk of firm. * If project risk is different than firm risk, must calculate project discount rate based on project risk. P/E ratio: Share Price EPS Market-to-book: Market Cap Common equity Market Cap: Share Price x # of shares EPS: Earnings # of shares Cost of Equity, no taxes: R S = cost of equity R B = cost of debt (8%) R 0 = cost of cap. for unlevered firm (10%) Firm has zero debt in cap structure. Overall cost of capital = 10%. Firm is considering 60% debt. Interest rate on debt = 8%. What is cost of equity capital in new structure? R s = R 0 + S (R 0 - R B ) B 13% = 10% + 40 (10% - 8%) 60 B = debt S = equity CAPM E(R i ) = R f +B i [E(R m ) - R f ] Expected Return = Current Risk-Free Rate + Risk Premium Typical Negative Covenant of a Loan Document include: * Limitations are placed on the amount of dividends a company may pay. * Firm may not pledge any of its assets to other lenders * Firm may not merge with another firm * Firm may not sell or lease its major assets without approval by lender * Firm may not issue additional long-term debt * Positive covenant = MUST do. Negative covenant = limit actions. Flow-To-Equity Approach to Capital Budgeting “Calculating the levered cash flow after interest expense, the cost of equity capital for a levered firm, and then discounting the levered cash flows by the cost of equity capital.” 1 Calculating levered cash flows 2 Calculating R s (discount rate) 3 Valuation * Proxy - grant of authority allowing someone else to vote your stock. * Proxy Fight - group other than mgmt. solicits authority to vote shares to replace mgmt. * Treasury Stock - Shares of stock repurchased by a corporation. * Red Herring - Prospectus, named b/c of red letters. * Tombstone Ads - Announcements of new issues that appear as ads in financial press. * Prospectus
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