10. FIN 301 - F09 Capital Struture

10. FIN 301 - F09 Capital Struture - Capital Structure...

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Capital Structure Lab 10
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2 Capital Structure and Firm Value Sources of funds: Debt after-tax cost of debt = R D  x (1-T) fraction of firm value financed by debt = w D Equity cost of equity = R E Fraction of firm value financed by equity = w E Is there an optimal mix of debt and equity (or an  optimal capital structure ) that minimizes the cost of  capital and maximizes the firm value?
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3 Financial Leverage Financial leverage is the extent to which a  firm uses debt financing versus equity  financing A firm that is all equity financed is an  unlevered   firm A firm that is financed by a mix of debt and  equity is a  levered firm
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4 Measuring Financial Leverage       Market Value of Debt Debt to Value Ratio Total Market Value D D D E V = = = + Market Value of Debt D Debt to Equity Ratio Market Value of Equity E = = D/V * Debt to Equity Ratio 1 - D/V 1 * Equity to Value Ratio 1 + D/E = =
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5 Modigliani and Miller Theorem – Case 1 Case 1 no tax and thus no tax savings for debt no financial distress or agency costs associated with debt it does not matter how the firm is “sliced” between debt and  equity holders, since neither more debt nor less debt has a value- adding effect the value of the levered firm is equal to that of unlevered D + E L   =   V V L   =   =  V  V U   = E U the cost of levered equity is computed as: R EL  = R EU  +  D / (R EU  – R D
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6 Example 1: The Wonderland White Rabbit Inc (WRI) is an all-equity financed firm worth $5 million  that’s operating in Wonderland where corporate tax rate is zero and 
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10. FIN 301 - F09 Capital Struture - Capital Structure...

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