Capital Structure

Capital Structure - Required Reading Chapter 15, Capital...

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1 Capital Structure Finance - I (MGCR 341) – Prof. de Motta Required Reading Chapter 15 , “Capital Structure” from Berk, De Marzo , and Harrod, Fundamentals of Corporate Finance. Finance - I (MGCR 341) – Prof. de Motta 2 ( This chapter starts on page 421 in the custom book ) Assets and Liabilities Typical Balance Sheet of Manufacturing Sector Assets Liabilities Current assets 39% Current liab. 28% Finance - I (MGCR 341) – Prof. de Motta 3 Net fixed aseets 36% Long-term liab. 34% Other long-term assets 26% Equity 37% Total assets 100% Total liabilities 100% D /( E + D ) Ratio for US Firms Finance - I (MGCR 341) – Prof. de Motta 4 Although firms have primarily issued debt rather than (external) equity, their leverage has not increased due to the growth in value of existing (internal) equity.
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2 Capital Structure Capital Structure: How the firm’s operations are financed. Q. How is the capital structure determined? Finance - I (MGCR 341) – Prof. de Motta 5 Q. Does the capital structure affect the value of the firm? Q. Does the capital structure affect the cost of capital? Capital Structure in Perfect Capital Markets Assume you operate in an environment, where 1) There are no taxes 2) There are no costs of financial distress. Finance - I (MGCR 341) – Prof. de Motta 6 3) There are no agency costs 4) No transaction costs 5) Efficient Capital Markets: No arbitrage opportunities ` Modigliani and Miller (M&M) Irrelevance Theorems M&M Proposition I (without taxes): The value of the firm is independent of its capital structure. M&M Proposition II (without taxes): The cost of capital of the firm ) ( Firm Levered of Value ) ( Firm Unlevered of Value L U V V Finance - I (MGCR 341) – Prof. de Motta 7 does not change with its leverage and hence, the cost of capital of the levered equity is: where r E is the cost of capital of the levered equity, r D is the cost of capital of the debt, r U is the cost of capital of the unlevered equity (sometimes also called the cost of capital of the assets, i.e., r A ), and E and D are the market value of the equity and the debt, respectively. E D ) r (r r r D U U E Example (M&M Proposition I without taxes) Consider two firms A and B with identical assets (in $M). Firm A is all equity financed and while Firm B has debt and equity with one year maturity and face value $60M show that the two firms have the same value. Asset value next year: Firm A Firm B In state 1: 160 160 In state 2: 40 40 Finance - I (MGCR 341) – Prof. de Motta 8 Solution Note that in both states of the world, the following the payoff to Firm A’s equity is equal The sum of payoffs to Firm B’s debt and equity and hence D(B) + E(B) = E(A) and therefore, V(A) = V(B) Claim’s value next year Firm A’s Equity Firm B’s Debt Firm B’s Equity In state 1: 160 60 100 In state 2: 40 40 0
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3 M&M Proposition I: Intuition 1. If Firm A were to adopt Firm B’s capital structure, its total value would not be affected (and vice versa); This is because ultimately, its value is that of the cash flows generated by its assets (e.g., plant and inventories).
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Capital Structure - Required Reading Chapter 15, Capital...

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