chapter13_1a - Chapter 13-1: Capital Structure Understand...

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Chapter 13-1: Capital Structure Understand the effect of financial leverage on firm value and cost of capital
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The Capital-Structure Question The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity. V = D + E The Capital Structure decision can be viewed as how best to slice up a pie. If how you slice the pie affects the size of the pie, then the capital structure decision matters. 70% Debt 30% Equity
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What is an optimal capital structure? D = market value of firm’s debt E = market value of firm’s equity V= D + E = market value of firm’s assets Questions: 1. Do shareholders want managers to maximize V or E? 2. Can we choose the ratio of D to E in a way that maximizes V?
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Maximizing V or E? Example: 100 shares selling at $10 each E 0 = 1000 Initially unlevered D 0 = 0 Firm value: V 0 = 1000 + 0 = 1000 Management of Sprint considers becoming levered Borrow $500 D 1 = 500 Use $500 to pay special dividend of $5 per share New firm value V 1 will be either: $1250, $1000, or $750
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Example (continued) What is the value of debt and equity with the leverage?
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chapter13_1a - Chapter 13-1: Capital Structure Understand...

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