FIN+4414+-+Capital+Structure+Decisions+-+Extensions+-+Chapter+17

FIN+4414+-+Capital+Structure+Decisions+-+Extensions+-+Chapter+17

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Capital Structure Decisions: Extensions
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Capital Structure Theories David Durand - 1952 : Net income approach Net operating income approach Traditional approach
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r S Debt Ratio r D r a Net Income Approach r S Constant r D Constant r a Decreases Value Increases
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Debt Ratio r S r D r a Net Operating Income Approach r S Increases r D Constant r a Constant Value Constant
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Debt Ratio r S r D r a Traditional Approach r S Increases r D Increases r a Decrease/Increase Value Increase/Decrease
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Capital Structure Theories Miller & Modigiani - Assumptions : Homogeneous risk classes. Homogeneous expectations. Perfect capital markets. All debt is riskless. All cash flows are perpetuities.
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Modigliani & Miller - No Taxes Miller & Modigiani - 1958 : No Taxes. Same as Durand’s net operating income approach. Value of the firm remains constant at all levels of debt. Capital structure is irrelevant.
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Modigliani & Miller - No Taxes Proposition I : V L = V U V L = EBIT / r SU = EBIT / r a Proposition II : r SL = r SU + (r SU - r D )(D/S)
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Debt Ratio r S r D r a Modigliani & Miller - No Taxes r S Increases r D Constant r a Constant Value Constant
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Debt Ratio Value Of Firm Modigliani & Miller - No Taxes V U V L = V U
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Modigliani & Miller - Example Assume two firms with the same risk class. The unlevered firm has expected EBIT of $1,000 and r S = 10%. The levered firm also has EBIT of $1,000 but has debt of $5,000 and a cost of debt, r D , of 5%.
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Modigliani & Miller - Example Unlevered Firm : r SU = r a = 10% V U = S U = EBIT / r a V U = [$1,000]/[.10] = $10,000
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Modigliani & Miller - Example Levered Firm : V L = V U = $10,000 S L = V L - D S L = $10,000 - $5,000 = $5,000
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Modigliani & Miller - Example Levered Firm : r SL = r SU + (r SU - r D )(D/S) r SL = .10 + (.10-.05)($5/$5) = 15% r a = (.05)(50%) + (.15)(50%) = 10%
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Modigliani & Miller - Arbitrage Now assume an investor can purchase 10 percent of either of the two firms: 10 percent of the stock of the unlevered firm and 10 percent of both the stock and debt of the levered firm. Arbitrage will force both firms to have the same value.
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Modigliani & Miller - Arbitrage Unlevered Firm : CF U = (10%)(EBIT) CF U = (10%)($1,000) = $100 Cost = (10%)($10,000) = $1,000
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Modigliani & Miller - Arbitrage Levered Firm : Interest = ($5,000)(.05) = $250 CF D = (10%)($250) = $25 CF S = (10%)(EBIT - Interest) = $75 CF L = $25 + $75 = $100 Cost = (.10)($10,000) = $1,000
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Modigliani & Miller - Arbitrage Cash Flow Unlevered Levered Stock $100.00 $75.00 Debt --- $25.00 Total $100.00 $100.00 Cost $1,000.00 $1,000.00
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Modigliani & Miller - Share Price Assume the firm is unlevered with N shares of stock, but then issues debt and uses the proceeds to repurchase M shares. Price will remain constant.
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Modigliani & Miller - Share Price V U = (N)(P U ) V L = (N - M)(P L ) + D V L = (N - M)(P L ) + (M)(P L ) V L = (N)(P L ) - (M)(P L ) + (M)(P L ) (N)(P L ) = V L = V U = (N)(P U )
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Modigliani & Miller - Taxes Miller & Modigiani - 1963 : Corporate (no personal) taxes.
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This note was uploaded on 07/13/2011 for the course FIN 4414 taught by Professor Staff during the Spring '08 term at University of Florida.

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FIN+4414+-+Capital+Structure+Decisions+-+Extensions+-+Chapter+17

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