Slide+12+-+MM+Propositions

Slide+12+-+MM+Propositions - Financial Leverage and Capital...

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Financial Leverage and Capital Structure Policy by Diep Duong
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Outline The Capital Structure Question The Effect of Financial Leverage Capital Structure and the Cost of Equity Capital M&M Propositions I and II with Corporate Taxes Bankruptcy Costs Optimal Capital Structure 16-2
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Capital Restructuring We are going to look at how changes in capital structure affect the value of the firm, all else equal Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets The firm can increase leverage by issuing debt and repurchasing outstanding shares The firm can decrease leverage by issuing new shares and retiring outstanding debt 16-3
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Choosing a Capital Structure What is the primary goal of financial managers? Maximize stockholder wealth We want to choose the capital structure that will maximize stockholder wealth We can maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC 16-4
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The Effect of Leverage How does leverage affect the EPS and ROE of a firm? When we increase the amount of debt financing, we increase the fixed interest expense If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders Leverage amplifies the variation in both EPS and ROE 16-5
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Capital Structure Theory Modigliani and Miller (M&M)Theory of Capital Structure Proposition I – firm value Proposition II – WACC The value of the firm is determined by the cash flows to the firm and the risk of the assets Changing firm value Change the risk of the cash flows Change the cash flows 16-6
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Capital Structure Theory Under Three Special Cases Case I – Assumptions No corporate or personal taxes No bankruptcy costs Case II – Assumptions Corporate taxes, but no personal taxes No bankruptcy costs Case III – Assumptions Corporate taxes, but no personal taxes Bankruptcy costs 16-7
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Case I – Propositions I and II Proposition I The value of the firm is NOT affected by
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This note was uploaded on 07/01/2010 for the course ECON 393 taught by Professor D during the Spring '10 term at Rutgers.

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Slide+12+-+MM+Propositions - Financial Leverage and Capital...

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