Lecture_wk9 - Capital Structure 1 From Perfect Markets to...

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Capital Structure 1 From Perfect Markets to Classical Taxation
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Topics Covered Leverage in a Perfect market How Leverage Influences Equity Returns The Debt (interest) Tax Shield The interaction of corporate taxes and personal taxes Classical Taxation and Imputation Taxation
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M&M (Debt Policy Doesn’t Matter) Modigliani & Miller Given investment policy, no taxes and perfect capital markets it makes no difference whether the firm borrows, or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure. Given investment policy, total future cash flow and risk are determined. How that total cash flow and risk is packaged between debt and equity doesn’t change the totals so it can’t change total value. Otherwise arbitrage (see p447)
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M&M (Debt Policy Doesn’t Matter) Assumptions By issuing 1 security (equity) rather than 2 (debt & equity), the company diminishes investor choice. This does not reduce value if: Investors do not need the choice, OR There are sufficient alternative securities Capital structure does not affect cash flows e.g... No taxes No transactions costs or bankruptcy costs No effect on management incentives
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Example - Macbeth Spot Removers - All Equity Financed 20 15 10 5 (%) shares on Return 2.00 1.50 1.00 $.50 share per Earnings 2,000 1,500 1,000 $500 Income Operating D C B A y Perpetuit Outcomes 10,000 $ Shares of Value Market $10 share per Price 1,000 shares of Number Data M&M (Debt Policy Doesn’t Matter) Expected outcome
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Example cont. 50% debt 30 20 10 0 (%) shares on Return 3 2 1 $0 share per Earnings 500 , 1 1,000 500 $0 earnings Equity 500 500 500 $500 Interest 000 , 2 1,500 1,000 $500 Income Operating C B A Outcomes 5,000 $ debt of ue Market val 5,000 $ Shares of Value Market $10 share per Price 500 shares of Number Data D More risky returns, but higher expected return
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Example - Macbeth’s - All Equity Financed - Debt replicated by investors . Who borrow to finance 50% of their share investment 30 20 10 0% (%) investment $10 on Return 3.00 2.00 1.00 0 $ investment on earnings Net 1.00 1.00 1.00 $1.00 10%) ([email protected] Interest : LESS 4.00 3.00 2.00 $1.00 shares two on Earnings D C B A Outcomes M&M (Debt Policy Doesn’t Matter)
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MM'S PROPOSITION I If capital markets are perfect,
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