{[ promptMessage ]}

Bookmark it

{[ promptMessage ]}

Capital Budgeting for Levered firm MMII

Capital Budgeting for Levered firm MMII - HAAS SCHOOL OF...

Info icon This preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
H AAS S CHOOL OF B USINESS U NIVERSITY OF C ALIFORNIA AT B ERKELEY UGBA 103 A VINASH V ERMA M ODIGLIANI -M ILLER P ROPOSITIONS II: C APITAL B UDGETING FOR THE L EVERED F IRM This teaching note assumes familiarity with the material in the text dealing with the debt policy [Chapters 18-20]. In keeping with the text, we shall be denoting cost of capital by r . 1. While Modigliani-Miller Proposition I [MM I] deals with the relationship between the value of the unlevered and that of the levered firm, Modigliani-Miller Proposition II [MM II] deals with the relationship among the cost of equity capital, cost of debt capital, and cost of capital for the firm as a whole, which is related to the expected return on the assets. As with MM I, there is a tax-corrected version of MM II. 2. We saw in the previous note that, according to MM I, under “ideal” circumstances: V V U L = . [1] where U V denotes value of the assets of an unlevered firm, and L V denotes the value of the assets of an otherwise identical levered firm. By balance sheet identity: L V D E U + . [2] where D denotes value of the debt, and E value of the equity, of the levered firm. 1 Now, we can estimate the cost of capital for the unlevered firm on the basis of what we learnt in the lecture note called “CAPM and Capital Budgeting.” When the levered firm issues debt, the cost of debt capital will be determined by the market. We want to determine the cost of equity capital for the levered firm in terms of these two known quantities, the cost of capital for the unlevered firm, and the cost of debt capital. In order to do that we need U V , E and D in the same equation. We can get these three in the same equation by putting equations [1] and [2] together: E D V U + = , or D V E U - = This enables us to conclude that the equity of the levered firm [Firm L ] can be thought of as a portfolio of V U and D with a fraction [ ] E V U invested in the assets of the unlevered firm, and a fraction [ ] E D - in the debt of the levered firm. Therefore, the cost of equity capital, which is the expected (or required ) return on the equity, will be a weighted average of the expected returns on the components of the portfolio. Or, algebraically: 1 Since the levered firm is the only firm here with debt, we need not continue to distinguish the debt and equity of the levered firm by subscript L . Modigliani-Miller Propositions II 1
Image of page 1

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
H AAS S CHOOL OF B USINESS U NIVERSITY OF C ALIFORNIA AT B ERKELEY UGBA 103 A VINASH V ERMA D UA U E r E D r E V r * * - = [3] where E r and D r denote the expected return on the equity and on the debt of the levered firm respectively, and UA r denotes the expected return on the assets 2 of the unlevered firm. Substituting E D V U + = in the numerator of the first term on the right, and gathering coefficients of the debt-equity ratio, [ ] E D , we get: ( 29 D UA UA E r r E D r r - + = * .
Image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern