Chap 15_Capital Structure - Capital Structure Click to edit...

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M G M T 50 5, Fa ll 20 RWJ, Chapters 15-17 Click to edit Master subtitle style Capital Structure
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M G M T 50 5, Fa ll 20 RWJ, Chapters 15-17 Two Main Questions 1. Does capital structure matter? In other words, does the mix of equity and debt affect firm value? 2. If so, why?
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M G M T 50 5, Fa ll 20 RWJ, Chapters 15-17 Till the late 1950’s attempts to explain these questions just pointed to correlations. No coherent theory. Major theoretical breakthrough: Miller, Modigliani (1958). Popularly known as M&M.
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M G M T 50 5, Fa ll 20 RWJ, Chapters 15-17 Capital Structure Does Not Matter M&M showed that under the following conditions, capital structure does not matter: No taxes or transaction costs (frictionless markets) No bankruptcy costs (debt is riskless) Investors have homogeneous expectations about the firm’s future earnings. Implies no agency problems, no adverse selection Lack of arbitrage Competition for abnormal profits, which should result in efficient prices Lesser Assumptions All cash-flows are perpetuities, with zero growth. Business risk measured by the standard deviation of the firm’s earnings before interest and taxes. Only two types of securities, Debt and Equity.
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M G M T 50 5, Fa ll 20 RWJ, Chapters 15-17 Is this worth a Nobel Prize? not matter. It obviously does. They show that, if it matters, it is because that one or more of the above mentioned assumptions are not true. By doing this, they eliminated the wild chase to find factors that explain capital structure.
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M G M T 50 5, Fa ll 20 RWJ, Chapters 15-17 Earnings are generated by underlying assets of the firm. Value is created by the expectations of the future earnings of the firm generated by these assets. Sales and Profits are not dependent on how the assets were financed. So, when there are no externalities, total value of the firm should not depend on how it is financed. Why is Capital Structure Irrelevant?
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M G M T 50 5, Fa ll 20 RWJ, Chapters 15-17 Proposition I: Firm value is independent of its leverage Proof uses the “no-arbitrage” condition. Arbitrage refers to the ability to make positive profits with no net investment and no net risk. They assume such opportunities do not exist. This simple and elegant method of proofing also became a significant contribution to financial theory. i.e. where VL, VU are the values of the levered and unlevered firm respectively, EBIT is the earnings before interest and taxes to be earned each year in perpetuity, WACC is the weighted average cost of capital, and KSU is the cost of equity capital for the unlevered firm.
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G M T 50 5, Fa ll 20 RWJ, Chapters 15-17 Arbitrage Proof When two, otherwise identical, companies differed only in the way they are financed and in their total market values (Debt + Equity), we can perform an arbitrage by buying the lower valued firm and selling the higher valued firm. While we can write equations to show this, we will
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This note was uploaded on 09/30/2011 for the course SCHOOL OF 101 taught by Professor Abc during the Fall '11 term at Binghamton University.

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Chap 15_Capital Structure - Capital Structure Click to edit...

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