mini-case-ch17

mini-case-ch17 - Chapter 17 Capital Structure Decisions...

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Unformatted text preview: Chapter 17 Capital Structure Decisions: Extensions MINI CASE David Lyons, CEO of Lyons Solar Technologies, is concerned about his firm’s level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies average about 30 percent debt, and Mr. Lyons wonders why they use so much more debt, and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant: a. Business Week recently ran an article on companies’ debt policies, and the names Modigliani and Miller (MM) were mentioned several times as leading researchers on the theory of capital structure. Briefly, who are MM, and what assumptions are embedded in the MM and Miller models? Answer: Modigliani and Miller (MM) published their first paper on capital structure (which assumed zero taxes) in 1958, and they added corporate taxes in their 1963 paper. Modigliani won the Nobel Prize in economics in part because of this work, and most subsequent work on capital structure theory stems from MM. Here are their assumptions: • Firms’ business risk can be measured by σ EBIT , and firms with the same degree of risk can be grouped into homogeneous business risk classes. • All investors have identical (homogeneous) expectations about all firms’ future earnings. • There are no transactions (brokerage) costs, either to individuals or to firms. • All debt is riskless, and both individuals and corporations can borrow unlimited amounts of money at the same risk-free rate. • All cash flows are perpetuities. This implies that firms and individuals issue perpetual debt, and also that firms pay out all earnings as dividends, hence have Mini Case: 17 - 1 zero growth. Additionally, this implies that expected EBIT is constant over time, although realized EBIT may turn out to be higher or lower than was expected. • In their first paper (1958), MM also assumed that there are no corporate or personal taxes. These assumptions--all of them--were necessary in order for MM to use the arbitrage argument to develop and prove their equations. If the assumptions are unrealistic, then the results of the model are not guaranteed to hold in the real world. b. Assume that firms U and L are in the same risk class, and that both have EBIT = $500,000. Firm U uses no debt financing, and its cost of equity is r sU = 14%. Firm L has $1 million of debt outstanding at a cost of r d = 8%. There are no taxes. Assume that the MM assumptions hold, and then: 1. Find v, s, r s , and WACC for firms U and L. Answer: First, we find Vu and V L : V U = sU r EBIT = 14 ....
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This note was uploaded on 04/12/2011 for the course ECON 101 taught by Professor Buddin during the Spring '08 term at UCLA.

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mini-case-ch17 - Chapter 17 Capital Structure Decisions...

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