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Chapters 14 &amp; 15. Capital structure and firm value POSTED

# Chapters 14 & 15. Capital structure and firm value POSTED

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Capital Structure and Firm Value Chapters 14 & 15 Finance 357

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Capital Structure The value of a firm is defined as the sum of its debt and equity Managers should choose the capital structure that they believe will have the highest firm value because this will be most beneficial to the firm’s stockholders.
Leverage and Firm Value Changes in capital structure benefit stockholders only if the value of the firm increases. TransAm Corporation currently has no debt in its capital structure. The firm is considering issuing debt to buy back some of its equity. Current Proposed Assets \$8,000 \$8,000 Debt 0 \$4,000 Equity \$8,000 \$4,000 Interest Rate 10% 10% Market Value / Share \$20 \$20 Shares Outstanding 400 200

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Leverage Effects Current capital structure with no debt Proposed capital structure EPS is higher, but risk is also higher Recession Expected Expansion Return on Assets 5% 15% 25% Earnings \$400 \$1,200 \$2,000 Return on Equity = Earnings/Equity 5% 15% 25% Earnings per Share \$1.00 \$3.00 \$5.00 Recession Expected Expansion Return on Assets 5% 15% 25% Earnings \$400 \$1,200 \$2,000 Interest -\$400 -\$400 -\$400 Earnings After Interest \$ 0 \$ 800 \$1,600 Return on Equity = Earnings after Interest / Equity 0% 20% 40% Earnings per Share \$ 0 \$4.00 \$8.00
Modigliani and Miller Proposition I So which capital structure is best? M&M Proposition I states that no capital structure is better or worse than any other for the firm’s stockholders. Recession Expected Expansion Strategy A: Buy 100 Shares of Levered Equity EPS of levered equity \$0 \$4 \$8 Earnings per 100 shares 0 \$400 \$800 Initial cost = 100 shares @\$20/share = \$2,000 Strategy B: Homemade Leverage – Borrowed Money Earnings per 200 shares in current unlevered TransAm \$1 x 200 = 200 \$3 x 200 = 600 \$5 x 200 = 1,000 Interest at 10% on \$2,000 -200 -200 -200 Net earnings 0 \$400 \$800 Initial cost = 200 shares @\$20/share - \$2,000 = \$2,000

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M&M I and Assumptions M&M Proposition I states that the value of the levered firm is the same as the value of the unlevered firm. Assumptions: No Taxes Investors can borrow as cheaply as corporations Individuals can usually borrow at rates similar to corporations with a margin account
M&M Proposition II M&M Proposition II states that the expected return on equity is positively related to leverage, because the risk to equity holders increases with leverage. Note that in our example, the unlevered firm has an expected return of 15% (ROE) and the levered firm an expected return of 20%. This is consistent with M&M Proposition II. Remember that the expected return is also the required return.

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Example of M&M II WACC formula with no taxes The cost of equity for the firm with different capital structures is:
Example of M&M II (cont’d) The WACC for the firm with different capital structures Notice that the WACC for the firm is the same regardless of capital structure M&M II states that the expected return on equity is positively related to leverage

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Making M&M More Realistic M&M I & II both assumed no taxes.
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Chapters 14 & 15. Capital structure and firm value POSTED

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