Lecture 5 - Capital Structure The MM Propositions Elena...

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Capital Structure: The MM Propositions Elena Simintzi COMM 370 1 Lecture 5: MM Propositions
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Ø We have left one major question unresolved: how do firms decide on their capital structure , i.e. the optimal mix of debt and equity? Ø In other words, leaving all else equal (i.e. with the firm having the same operations and projects and, so, the same unlevered cash flows), what is the optimal capital structure? o is it possible to increase the firm value just by changing the mix of securities issued? o is there an optimal level of leverage and if so, what is it? and how is it determined? To answer that question, consider the goal of financial managers: o Maximize shareholder wealth, i.e. maximize the market value of equity E Therefore, the optimal capital structure is the one that maximizes shareholder wealth (i.e. the market value of equity ) It can be shown that shareholder wealth E is maximized when the value of the firm V (i.e. the market value of the assets ) is maximized Choosing Capital Structure 2 Lecture 5: MM Propositions
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Some Empirical facts Lecture 5: MM Propositions 3 Ø On average across all public & private firms, firms have leverage ratios around 30% and this is remarkably stable over time. Ø Market leverage ratios are affected by stock prices, and thus are more volatile than book ratios. Ø There are large differences in the debt ratios across industries, possibly related to factors such as capital intensity or technology. Ø Even within an industry, firms may have very different debt ratios. Ø Firms choose a target debt ratio and try to stay close to it. This target differs across firms and industries, and it varies over time.
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4 Aggregate Balance Sheet for U.S. Manufacturing Firms ($ billions, data for 2007) Current assets $2,002 Current liabilities $1,471 Net fixed assets $1,173 Total long-term liabilities $1,995 Other assets $2,986 Stockholder's equity $2,695 Total assets $6,161 Total liabilities & equity $6,161 Source: U.S. Census Bureau, Quarterly Financial Report for Manufacturing Note that long-term debt / total assets = 32.4%. This is for all US manufacturing companies (public and private). Lecture 5: MM Propositions
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5 Avg. Leverage for 246 Non-Financial Industries 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Book Leverage = BVD / TA Market Leverage = BVD / (MVE + BVD) This is for non-financial and publicly traded companies in Compustat Lecture 5: MM Propositions
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6 Financial Leverage in 2007 Across 246 Industries Value corresponding to percentile: 1% 5% 10% 25% 50% 75% 90% 95% 99% Book 0.0% 0.4% 2.6% 12.3% 22.0% 30.0% 38.7% 47.5% 62.7% Market 0.0% 0.3% 1.8% 8.1% 17.0% 27.5% 37.0% 47.5% 63.6% Source: Compustat (public firms only) Lecture 5: MM Propositions
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7 Top 10 Industries According to Book Leverage in 2007 Knitting Mills 67.9% Guided Missiles And Space Vehicles And Parts 57.4% Metal Cans And Shipping Containers 49.2% Paperboard Mills 42.5% Cigarettes 37.9% Motorcycles, Bicycles, And Parts 37.1% Industrial Organic Chemicals 36.8% Iron And Steel Foundries 36.6% Pulp Mills 36.1% Fabricated Structural Metal Products 30.7% Carpets And Rugs 30.5%
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