Handout 2A - Optimal Capital Structure 1 MM Propositions(No...

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2A-1 Corporate Finance © Professor Ho-Mou Wu Spring 2004 Optimal Capital Structure Optimal Capital Structure 1. MM Propositions (No Tax) 2. MM Propositions (with Corporate Taxes) 3. Costs of Financial Distress 4. Optimal Capital Structure
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2A-2 Corporate Finance © Professor Ho-Mou Wu Spring 2004 1. Modigliani-Miller World (No tax) Assumptions of the Modigliani-Miller Model (1) Homogeneous Expectations (2) Homogeneous Business Risk Classes (3) Perpetual Cash Flows (4) Perfect Capital Markets: Firms and investors can borrow/lend at the same rate Perfect competition Equal access to all relevant information No transaction costs No taxes
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2A-3 Corporate Finance © Professor Ho-Mou Wu Spring 2004 Homemade Leverage: An Example Example 1: Recession Expected Expansion EPS of Unlevered Firm $2.50 $5.00 $7.50 Earnings for 40 shares $100 $200 $300 Less interest on $800 (8%) $64 $64 $64 Net Profits $36 $136 $236 ROE (Net Profits / $1,200) 3% 11% 20% We are buying 40 shares of a $50 stock on margin. We get the same ROE as if we bought into a levered firm. Our personal debt equity ratio is: 3 2 200 , 1 $ 800 $ = = S B
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2A-4 Corporate Finance © Professor Ho-Mou Wu Spring 2004 Homemade (Un)Leverage: An Example Recession Expected Expansion EPS of Levered Firm $1.50 $5.67 $9.83 Earnings for 24 shares $36 $136 $236 Plus interest on $800 (8%) $64 $64 $64 Net Profits $100 $200 $300 ROE (Net Profits / $2,000) 5% 10% 15% Buying 24 shares of an other-wise identical levered firm along with the some of the firm’s debt gets us to the ROE of the unlevered firm. Capital structure does not matter. This is the fundamental insight of M&M
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2A-5 Corporate Finance © Professor Ho-Mou Wu Spring 2004 Proposition I Firm value is not affected by leverage 0
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2A-6 Corporate Finance © Professor Ho-Mou Wu Spring 2004 MM Proposition I (No Tax) U L V V = B r EBIT B - receive firm levered a in rs Shareholde B r B receive s Bondholder The derivation is straightforward : B r B r EBIT B B + - ) ( is rs stakeholde all to flow cash total the Thus, The present value of this stream of cash flows is V L EBIT B r B r EBIT B B = + - ) ( Clearly The present value of this stream of cash flows is V U
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2A-7 Corporate Finance © Professor Ho-Mou Wu Spring 2004 MM (No Tax)-Arbitrage Argument Unlevered Firm (U): , Net Income EBIT Levered Firm (L): , Net Income EBIT-r B Strategy : Buy α% of the levered firm (L), Cash outflow Strategy : Buy α % of the unlevered firm (U) and borrow α % of B Cash outflow U U S V = B S V L L + = ) ( B V α S α L L - = B α V α B α S α u U - = -
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2A-8 Corporate Finance © Professor Ho-Mou Wu Spring 2004 Suppose An Arbitrage Opportunity exists, short and long : Net Cash Flows Incomes in the future: Short I: Long II: 0 Hence, riskless profits now rB α EBIT α - U L V V 0 ) ( ) ( ) ( - = - - - = U L u L V V α B α V α B V α ) ( rB EBIT α - - MM-Arbitrage Argument
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2A-9 Corporate Finance © Professor Ho-Mou Wu
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This note was uploaded on 01/23/2011 for the course FGB 780 taught by Professor Edwardchang during the Spring '09 term at Missouri State University-Springfield.

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Handout 2A - Optimal Capital Structure 1 MM Propositions(No...

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