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Lecture9 - capital structure theory

E rb rf and substitute into prop ii prop rs rf

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Unformatted text preview: sing 22 Implications of MM2 for CAPM SML: r0 = rF + βU(rM-rF) Assume debt beta is zero (i.e., rB = rF), and substitute into ), Prop. II: Prop. rS = rF + βU(rM-rF) + βU(rM-rF)(1-T)(B/S) )(1-T)(B/S) = rF + βU[1+(1-T)(B/S)](rM-rF) We also know that rS = rF + βL(rM-rF) Therefore β L = β U [1+(1-T)(B/S)] Therefore In our previous notation, this is just βS = βA [1+(1-T)(B/S)] 23 Implications of MM2 for CAPM (new 23) From CAPM: r0 = rF + βU(rM – rF) or r0 – rF = βU(rM – rF) (1) or MM2 when βD = 0 (rB = rF): rS = r0 + (r0 – rF)(1 – t)B/S (2) MM2 (1) into (2): rS = rF + βU(rM – rF) + βU(rM – rF)(1 – t)B/S )(1 rS = rF + βU[1 + (1 – t)B/S](rM – rF) (3) From CAPM: rS = rF + βL(rM – rF) From (4). Plug (4) into (3): rF + βL(rM – rF) = rF + βU[1 + (1 – t)B/S](rM – rF) Thus, βL = βU[1 + (1 – t)B/S] Thus, In our previous notation, this is βS = βA[1 + 24 – t)B/S] (1 In 25 Summary of MM Propositions MM1 with taxes VU + TCB = VL Since firm value always increases in leverage, the Since optimal capital structure is 100% debt! optimal MM2 with taxes rS = r0 + (r0-rB)(B/S)(1-TC) It implies that WACC decreases in leverage, thus increasing firm value. Same conclusion! increasing MM1 with no taxes VU = VL Capital structure is irrelevant! MM2 with no taxes rS = r0 + (r0-rB)(B/S) It implies that WACC is not affected by leverage, thus not It 26 changing firm value. Same conclusion! changing The Static Tradeoff Theory MM2 leaves us far away from a theory of capital structure: MM2 the optimal would be 100% debt the But we do not observe this in reality… We are missing the costs of having higher levels of We debt! debt! There are several important costs associated with debt There financing. Though more difficult to quantify, these are no less relevant than the tax effects of debt. less A trade-off between benefits and costs of debt will give us a theory of optimal capital structure, rather than more debt is always better. 27 The Static Tradeoff Theory What are these costs of debt? Look behind the MM What assumptions!! assumptions!! Main issue is that in practice capital structure may affect Main the cash flows to the firm the The original theory talks about costs of financial distress The costs – Direct Costs: legal, administrative and accounting Direct (about 3% o...
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