Lecture 38 - Business Finance (ACC501) Lesson 38 Review of...

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195 Business Finance (ACC501) Lesson 38 Review of the Previous Lecture Capital Structure Financial Leverage Homemade Leverage Unlevering Topics under Discussion M&M Propositions Business and Financial Risk Corporate Taxes & Capital Structure M&M Propositions We have seen that corporate borrowing is relatively less significant when it comes to corporate structure, because investors can borrow or lend on their own. So, in our TA corporation, the stock price remains almost the same whichever capital structure company chooses. This result is based upon a famous argument by two noble laureates, Franco Modigliani and Merton Miller (commonly known as M&M). We shall discuss the two propositions presented by M&M. The 1 st proposition states that it is completely irrelevant how a firm chooses to arrange its finances. Imagine two firms having identical assets and operations depicted on the left hand side of the balance sheet. But the right hand side is different because the two firms finance their operations differently. In this case we can view the capital structure question in terms of a pie model.

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196 The size of the pie does not depend on how it is sliced Although changing the capital structure may not change the firm’s total value, it does cause important changes in the firm’s debt and equity. Now we examine the firm which changes its debt-equity ratio; and for simplification we ignore taxes here. We know that WACC = (E/V) x R E + (D/V) x R D where V = E + D We also know that WACC can be interpreted as the required return on the firm’s overall assets (R A ). Thus R A = (E/V) x R E + (D/V) x R D Rearranging R E = R A +(R A – R D ) x (D/E) This 2 nd proposition tells us that the cost of equity depends on three things The required return on firm’s assets R A The firm’s cost of debt R D , and 70% Debt 30% Equity 70% Equity 30% Debt
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This note was uploaded on 08/04/2011 for the course ACCT 501 taught by Professor Na during the Spring '11 term at Virtual University of Pakistan.

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Lecture 38 - Business Finance (ACC501) Lesson 38 Review of...

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