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Unformatted text preview: 1 Chapter 16 Capital Structure Decisions: Part II 2 Topics in Chapter MM models, with and without corporate taxes Miller model, with corporate and personal taxes Extension to MM when there is growth and the tax shield is risky Equity as an option 3 Who are Modigliani and Miller (MM)? They published theoretical papers that changed the way people thought about financial leverage. They won Nobel prizes in economics because of their work. MM’s papers were published in 1958 and 1963. Miller had a separate paper in 1977. The papers differed in their assumptions about taxes. 4 What assumptions underlie the MM and Miller Models? Firms can be grouped into homogeneous classes based on business risk. Investors have identical expectations about firms’ future earnings. There are no transactions costs. (More. ..) 5 All debt is riskless, and both individuals and corporations can borrow unlimited amounts of money at the riskfree rate. All cash flows are perpetuities. This implies perpetual debt is issued, firms have zero growth, and expected EBIT is constant over time. (More. ..) 6 MM’s first paper (1958) assumed zero taxes. Later papers added taxes. No agency or financial distress costs. These assumptions were necessary for MM to prove their propositions on the basis of investor arbitrage. 7 Proposition I: V L = V U . Proposition II: r sL = r sU + (r sU r d )(D/S). MM with Zero Taxes (1958) 8 Given the following data, find V, S, r s , and WACC for Firms U and L. Firms U and L are in same risk class. EBITU,L = $500,000. Firm U has no debt; r sU = 14%. Firm L has $1,000,000 debt at r d = 8%. The basic MM assumptions hold. There are no corporate or personal taxes. 9 V U = = = $3,571,429. V L = V U = $3,571,429. EBIT r sU $500,000 0.14 1. Find V U and V L . 10 V L = D + S = $3,571,429 $3,571,429 = $1,000,000 + S S = $2,571,429. 2. Find the market value of Firm L’s debt and equity. 11 r sL = r sU + (r sU r d )(D/S) = 14.0% + (14.0%  8.0%) ( ) = 14.0% + 2.33% = 16.33%. $1,000,000 $2,571,429 3. Find r sL . 12 WACC = w d r d + w ce r s = (D/V)r d + (S/V)r s = ( ) (8.0%) + ( ) (16.33%) = 2.24% + 11.76% = 14.00%. $1,000,000 $3,571,429 $2,571,429 $3,571,429 4. Proposition I implies WACC = r sU . Verify for L using WACC formula. 13 Without taxes Cost of Capital (%) 26 20 14 8 20 40 60 80 100 Debt/Value Ratio (%) r s WACC r d MM Relationships Between Capital Costs and Leverage (D/V) 14 The more debt the firm adds to its capital structure, the riskier the equity becomes and thus the higher its cost. Although rd remains constant, r s increases with leverage. The increase in r s is exactly sufficient to keep the WACC constant. 15 Value of Firm, V (%) 4 3 2 1 0.5 1.0 1.5 2.0 2.5 Debt (millions of $) V L V U Firm value ($3.6 million) With zero taxes, MM argue that value is unaffected by leverage....
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This note was uploaded on 04/08/2011 for the course FIN 360 taught by Professor Smith during the Spring '10 term at Park.
 Spring '10
 SMITH

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