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Session2-lecture2009

# Session2-lecture2009 - Session 2 RWJ In this session we...

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Session 2 RWJ, Chapters 15, 16 In this session we will study Capital Structure, that is the structure of financing and consequent ownership for a firm. Does Capital Structure matter is one of the basic questions in corporate finance, and the answer provided by the Modigliani Miller (MM) theorem is “No”. MM makes some strong assumptions like there are no tax advantages to debt, and is therefore obviously false. It is however the most useful starting point for analyzing questions related to financing, payment of dividends etc. We next consider deviations in the real world from MM assumptions like the tax benefit of debt, the use of debt for signaling, etc. These deviations mean that MM does not hold in the real world. We end the session with a discussion of how firms choose their capital structure. The Capital Structure The value of the firm equals the market value of the debt plus the market value of the equity (firm value identity). This is just: V = D + E. The goal of management should be to maximize the value of equity. If the management is barred from transferring value from debt to equity (for example by debt covenants) then the goal becomes equivalent to maximizing the value of the firm, that is the sum of debt plus equity. From the operations point of view , by doing a positive NPV project the firm adds value. The question from the financing point of view is what is how should be firm finance its projects? Does mix of financing chosen by a firm determines its capital structure. What is the optimal capital structure or are all capital structures equal (irrelevant)? Financial Leverage and Firm Value: An Example Consider the following firm: Current Proposed Assets \$5,000,00 0 \$5,000,00 0 Debt 0 2,500,000 Equity 5,000,000 2,500,000 D/E ratio 0 1 Share price (assume it does not change when shares are repurchased) \$10 \$10 Shares outstanding 500,000 250,000 Interest Rate N/A 10%

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Current capital structure: No debt Recession Expected Expansion EBIT \$300,000 \$650,00 0 \$1,000,000 Interest Expense 0 0 0 Net Income \$300,000 \$650,00 0 \$1,000,000 ROE 6% 13% 20% EPS \$0.60 \$1.30 \$2.00 Proposed capital structure: D/E = 1; interest rate = 10% Recession Expected Expansion EBIT \$300,000 \$650,00 0 \$1,000,000 Interest Expense 250,000 250,000 250,000 Net Income \$50,000 \$400,00 0 \$750,000 ROE 2% 16% 30% EPS \$0.20 \$1.60 \$3.00 We can conclude that: -The effect of financial leverage depends on EBIT. -Financial leverage increases ROE and EPS when EBIT is greater than the cross-over point. -The variability of EPS and ROE is increased with leverage. If management’s goal is to maximize value of firm, then the “optimal” or “target” capital structure is the debt/equity mix that simultaneously (a) maximizes the value of the firm, (b) minimizes the weighted average cost of capital, and (c) maximizes the market value of the common stock. The Modigliani Miller Theorem The Choice between Debt and Equity: We have shown that leverage affects earnings and returns; however, the question remains, “does it impact the value of the firm?” Modigliani and Miller (MM) suggest in a “perfect world” that the value of the firm does not change in response to changes in capital structure.
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