lecture_debt_policy_521_2011

lecture_debt_policy_521_2011 - Debt Policy M&M propositions...

Info icon This preview shows pages 1–9. Sign up to view the full content.

View Full Document Right Arrow Icon
1 Debt Policy M&M propositions 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
Image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
2 M&M Proposition Modigliani & Miller (again) 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
Image of page 2
3 M&M’s Key Assumptions 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
Image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
4 M&M Basic Result on Capital Structure 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).
Image of page 4
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
Image of page 5

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
6 Leverage and WACC under MM Debt/Equity Expected Returns r A Debt becomes risky r E r D
Image of page 6
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?
Image of page 7

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
8 Violations of M&M’s Propositions When might firm value depend upon its financing? When might firm have preference for one type of financing over another?
Image of page 8
Image of page 9
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern