3_capitalstructurenewest

3_capitalstructurenewest - CAPITAL STRUCTURE The...

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Capital Structure - Dr. Shlomit Zuta 1 CAPITAL STRUCTURE The "capital structure" of a firm refers to the chosen mix between sources of funds For simplicity, sources of funds are catagorized as debt or equity In this lecture we will Analyze the impact of capital structure decisions on firm’s value and required return Start with the Modigliani and Miller (M&M) analysis without taxes Consider taxation Consider financial distress Consider other reasons for choosing different types of financing
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Capital Structure - Dr. Shlomit Zuta 2 The Value of a Firm The value of a firm “ V ” is the present value of all its future cash flows: where R is the risk-adjusted discount rate for the firm For illustrative purposes in this lecture we will consider the case where the cash flows each period are the same, say $C Now the value of the firm is given by the perpetuity calculation: + = = 1 ) 1 ( i i i R C V R C V =
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Capital Structure - Dr. Shlomit Zuta 3 Two types of people have invested in the firm, debtholders and equityholders Both have claims to the firm’s cash flows Debtholders have been promised fixed payments each period Equityholders own whatever is left after the debtholders have been paid (residual claimants) Equityholders also make the decisions pertaining to the firm Together the debtholders and equityholders have claims against the entire firm, therefore: V = D + E
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Capital Structure - Dr. Shlomit Zuta 4 The M&M Analysis Main Assumptions No taxes Debt is risk-free and there are no financial distress costs Companies and individuals borrow at the same interest rate No arbitrage opportunities exist No transaction costs Everyone has “ homogeneous expectations
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Capital Structure - Dr. Shlomit Zuta 5 Proposition I (no tax case) The market value of a firm is independent of its capital structure. Changing a company's debt-to-equity ratio will only change the way the company's cash flows are divided between debtholders and equityholders but will not change the value of the firm Any capital structure choice will do! Is this an attractive model?
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Capital Structure - Dr. Shlomit Zuta 6 Proposition II : (no tax case) The return to equityholders of a levered firm rises with leverage (measured by the debt-to-equity ratio) where: r EL = return on equity of the levered firm r EU = return on equity of the unlevered firm r d = return on debt D L = amount of debt in the levered firm L L d U E U E L E E D r r r r ) ( - + =
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Capital Structure - Dr. Shlomit Zuta 7 Interpretation As leverage increases more risk has to be born by equityholders Hence they demand a higher rate of return The debt/equity ratio measures the risk transferred to equityholders r EU - r d measures the premium for each additional unit of risk This is in the spirit of the CAPM
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Capital Structure - Dr. Shlomit Zuta 8 Proposition II can be obtained from WACC:
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3_capitalstructurenewest - CAPITAL STRUCTURE The...

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