Chapter 15 - Chapter 15 Capital Structure 1. What is an...

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Chapter 15 Capital Structure
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1. What is an optimal capital structure? D = market value of firm’s debt E = market value of firm’s equity V= D + E = market value of firm’s assets Questions: Do shareholders want managers to maximize V? Can we choose D in a way that maximizes V?
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2. Maximizing V as a corporate financial objective Example: J.J. Sprint Co 100 shares selling at $10 each  E0 = 1000 Initially unlevered  D0 = 0 Firm value: V0 = 1000 + 0 = 1000 Management of Sprint considers becoming levered Borrow $500  D1 = 500 Use $500 to pay special dividend of $5 per share New firm value V1 will be either: 1250, 1000, or 750
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Example (continued) What is the value of debt and equity with the leverage? How much do shareholders profit/lose from increase in leverage? Conclusion: Maximizing V is the same as maximizing shareholder profit How do we maximize V? Is V affected by the amount of debt? V 0 = 1,000 V 1 =1,250 V 1 =1,000 V 1 =750 Debt Value 0 500 500 500 Equity Value 1,000 750 500 250 V 1 =1250 V 1 =1000 V 1 =750 Capital gains -250 -500 -750 Dividends 500 500 500 Shareholder profit 250 0 -250
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3. Theory of Optimal Capital Structure In a perfect world V is unaffected by capital structure What do we mean by a perfect world? No taxes, no bankruptcy costs, perfectly efficient markets Why does the M&M result result hold? Strategy 1 - Invest in an unlevered firm All earnings paid as dividends Individual purchases 15% of firm’s stock Initial Investment Expected cash flow to investor .15Vu .15(earnings)
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(continued) Strategy 2 - Invest in a levered firm Assume levered and unlevered firm have same earnings Annual interest of r on debt DL for payment of r x DL Individual purchases 15% of firm’s stock Initial Investment Expected cash flow to investor .15(VL – DL) .15(earnings – r x DL) Strategy 3 - Invest in the unlevered firm, borrow .15DL at interest rate r Strategy is known as the homemade leverage strategy Individual purchases 15% of firm’s stock Initial Investment Expected cash flow to investor .15VU – .15DL .15(earnings) – .15(r x DL) = .15(earnings – r x DL)
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(continued) Expected cash flow from strategy 2 and strategy 3 are equal  Initial investments must be equal  .15(VL- DL) = .15VU - .15DL VL = VU What happens if VL > VU? Everyone would follow strategy 3
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This note was uploaded on 10/17/2011 for the course ECON 101 taught by Professor Thompson during the Spring '11 term at Michigan State University.

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Chapter 15 - Chapter 15 Capital Structure 1. What is an...

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