lecture_debt_policy_521_2011

lecture_debt_policy_521_2011 - Debt Policy M&M...

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1 Debt Policy Effect of leverage on firm value, cost of debt, cost of equity, and expected return on assets Debt Policy and Market Imperfections Taxes Financial Distress Asymmetric Information Trade-off vs. Pecking Order Theory
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2 When there are no taxes, no transaction costs, and efficient capital markets, it makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a firm does not depend on its capital structure. DEBT POLICY DOES NOT MATTER FIRM CANNOT INCREASE VALUE BY ADJUSTING CAPITAL STRUCTURE
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3 By issuing one security (just equity or just debt), the company diminishes investor choice. This does NOT reduce firm value if: Investors do not need choice, OR There are sufficient alternative securities Capital Structure does not affect cash flows: No tax implications No asymmetric information No financial distress costs No effect on management incentives
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4 As long as individuals can borrow or lend at the same terms as the firm, they can undo any changes in the firm’s capital structure (just like individuals can undo dividend policy). Thus, market value of firm is independent of its capital structure. Firm value determined by real assets, and not the mix of securities (debt and equity) used to finance those assets. Conservation of Value: Value of pie is independent of how it is sliced (as long as nothing is lost during the slicing like taxes).
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5 MM’s key point about capital structure and security returns Change in capital structure does not affect the amount or riskiness of the cash flows generated by the firm’s assets (the firm’s total package of debt and equity). Thus, the investment and financing decisions are independent. Required Return on package of debt and equity unaffected by change in capital structure, although required return on individual securities is affected by it
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6 Leverage and WACC under MM Debt/Equity Expected Returns r A Debt becomes risky r E r D
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7 Leverage and Returns (cont.) Recall: r A = (D/V)*r D + (E/V)*r E r E = r A + (D/E)(r A – r D ) Likely the case that debt is risk-free at low debt levels. Thus, r D will not vary with D/E and r E will vary linearly with D/E at low leverage. As firm borrows more, risk of default may increase enough to cause r D to rise (bond holders require higher return). In this case, the rate of increase of r E will slow down (return on equity becomes less sensitive to D/E as D/E increases). Why?
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When might firm value depend upon its financing?
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lecture_debt_policy_521_2011 - Debt Policy M&M...

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