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FIN 620-session 4 lecture

FIN 620-session 4 lecture - FIN 620 Long-Term Financial...

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FIN 620 Long-Term Financial Management Session 4  1. Lecture Notes/Comments RWJ, Chapters 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)?
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