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16 - Financial Leverage and Capital Structure Chapter...

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Financial Leverage and Capital Structure Chapter Sixteen
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Chapter Outline The Capital Structure Question The Effect of Financial Leverage Capital Structure and the Cost of Equity Capital M&M Propositions I and II with Corporate Taxes Bankruptcy Costs Optimal Capital Structure The Pie Again Observed Capital Structures A Quick Look at the Bankruptcy Process
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Capital Restructuring We are going to look at how changes in capital structure affect the value of the firm, all else equal Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets Increase leverage by issuing debt and repurchasing outstanding shares Decrease leverage by issuing new shares and retiring outstanding debt
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Choosing a Capital Structure What are the goals of financial managers? !! Maximize Wealth,Maximize the Value of the Firm !! Choose the capital structure to do so Maximize Cash Flows Minimize WACC ( 29 ( 29 ( 29 1 2 0 2 1 1 1 n n CFFA CFFA CFFA Value CFFA WACC WACC WACC = + + +⋅⋅⋅+ + + + ( 29 1 E D E D WACC R R t V V = + -
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Capital Structure Theory Under Three Special Cases by Modigliani and Miller (M&M) Case I – Assumptions No corporate or personal taxes No bankruptcy costs Case II – Assumptions Corporate taxes, but no personal taxes No bankruptcy costs Case III – Assumptions Corporate taxes, but no personal taxes Bankruptcy costs
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Capital Structure Theory For each case there are two propositions Proposition I – focus on firm value Proposition II – focus on returns, WACC The value of the firm is determined by the cash flows to the firm and the risk of the cash flows generated by the assets To Change Firm Value: Change the cash flows OR Change the riskiness of the cash flows (WACC)
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Case I ( 29 ( 29 ( 29 1 2 0 2 1 1 1 n n CFFA CFFA CFFA Value CFFA WACC WACC WACC = + +
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