lecture9-819 - Capital Structure Some classic results and...

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FIN 819 Capital Structure Some classic results and arguments
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FIN 819 Today’s plan Review of the key ideas in option pricing Investment Decision vs. Financing Decision Advantages and shortcomings of debt Optimal capital structure The capital structure without corporate taxes Capital structure with corporate taxes Two theories for the optimal capital structure in the real financial world.
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FIN 819 Key ideas in option pricing There are two important ideas in option pricing No arbitrage argument Replicating portfolios These two ideas have a lot of applications. Get the PV of a piece of uncertain cash flow in the future Used to show or derive a lot of important results in modern finance (two famous examples) Black-Sholes formula Capital structure irrelevancy in the case of no corporate tax The no arbitrage condition is a much weaker condition than the equilibrium one, and thus has been widely applied in finance.
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Financial management: lecture 10 Look at the both sides of a balance sheet Asset Liabilities and equity Market value of the asset V Market value of equity E Market value of debt D V=E+D
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The choice of financing As shown in the previous slide, there are two ways for a firm to raise capital or money. The first is debt. The essence of debt is that you promise to make fixed payments in the future (interest payments and repaying principal). If you fail to make those payments, you lose control of your firm. The other is equity. With equity, you do get whatever cash flows are left over after you have made debt payments FIN 819
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Equity or debt financing FIN 819
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FIN 819 Capital structure Capital structure Capital structure refers to the mix of debt and equity of a firm. Measure of capital structure Ratio of D/E Ratio of D/V, V= E+D, the firm’s value or asset value
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Capital structure (continues) The question we will examine in capital structure is to examine what is the optimal amount of debt a firm should have to maximize a firm’s value? Or what is the optimal mix of Debt (D) and Equity or the ratio of D/E or D/V? FIN 819
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How much debt? Benefits of debt • Tax savings • Adds discipline to management May send a strong signal to investors Costs of debt Bankruptcy costs • Agency costs • Loss of future flexibility FIN 819
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Tax Benefits of Debt When you borrow money, you are allowed to deduct interest expenses from your income to arrive at taxable income. This reduces your taxes. When you use equity, you are not allowed to deduct payments to equity (such as dividends) to arrive at taxable income. The dollar tax benefit from the interest payment in any year is a function of your tax rate and the interest payment: Tax benefit each year = Tax Rate * Interest Payment Observation 1: Other things being equal, the higher the tax rate of a business, the more debt it will have in its capital structure.
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