Chapter 17

Chapter 17 - Capital Structure - Chapter 17 Yihui Wang...

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Capital Structure -- Chapter 17 Yihui Wang Capital Structure
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Main Issues • The Effect of Leverage • Capital Structure and Firm Value (MM Proposition I) • Capital Structure and Cost of Capital (MM Proposition II) • Add corporate taxes • Add bankruptcy costs • Optimal Capital Structure Capital Structure 2
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e Capital Structure Questions The Capital Structure Questions • How should companies finance their operations? • Does our investment activities depend upon our financing policies? • Does a particular mix of debt/equity result in a higher firm value? • Is there an optimal mix of debt and equity that results h h ih i b l f i l ? in the highest possible firm value? Capital Structure 3
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The Effect of Leverage apital restructuring: changing leverage without Capital restructuring: changing leverage without changing the firm’s assets. • Leverage amplifies the variation in cash flows to gp shareholders, both EPS and ROE • When we increase the amount of debt financing, we increase the fixed interest expense • If we have a really good year, then we have more left er for our stockholders after paying interest over for our stockholders after paying interest • If we have a really bad year, we still have to pay the same interest and we have less left over for our stockholders Capital Structure 4
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Example Capital Structure 5
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Example (con’t) Capital Structure 6
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Example (con’t) Capital Structure 7
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Capital Structure Theory di li i d Mill Th f C it l St t Modigliani and Miller Theory of Capital Structure Proposition I – firm value roposition II ACC Proposition II – WACC • Start with perfect market dd corporate taxes Add corporate taxes Add bankruptcy costs • The value of the firm is determined by the cash flows from y the assets and the risk of the assets. Firm value changes if Cash flows change Capital Structure Risk of the cash flows changes 8
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iller & Modigliani: roposition I Miller & Modigliani: Proposition I • In perfect capital markets, stockholders are indifferent to the choice of capital structure. The choice of capital structure ff i h kh ld l h fi has no effect on either stockholder wealth or firm value. MM Proposition I h t i f t k t? What is a perfect market? No taxes o transactions costs of any kinds No transactions costs of any kinds No information assymetries hese are not realistic descriptions of the “real world” Capital Structure These are not realistic descriptions of the real world 9
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Chapter 17 - Capital Structure - Chapter 17 Yihui Wang...

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