Lecture 5 mm propositions 8 bottom 10 industries

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Lecture 5: MM Propositions
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8 Bottom 10 Industries According to Book Leverage in 2007 Communications Equipment 5.7% Ship And Boat Building And Repairing 5.6% Electric Transmission And Distribution Equipment 5.4% Watches, Clocks, Clockwork Operated Devices, and Parts 5.4% Electrical Industrial Apparatus 5.1% Surgical, Medical, And Dental Instruments And Supplies 5.0% Drugs 4.7% Electronic Components And Accessories 4.1% Laboratory Apparatus and other instruments 2.6% Computer And Office Equipment 0.7% Lecture 5: MM Propositions
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9 Book Leverage of Main Public Firms in SIC 204 - Grain Mill Products – 2007 NEW DRAGON ASIA CORP 0.0% AGFEED INDUSTRIES INC 4.8% BUNGE LTD 20.7% CORN PRODUCTS INTL INC 20.9% GRUMA SAB DE CV 23.2% PENFORD CORP 27.8% GENERAL MILLS INC 36.8% KELLOGG CO 45.9% Lecture 5: MM Propositions
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10 Terms and Notation Levered firm (L) : a firm that has issued some debt V L : total market value of a levered firm ( V L = D + E L ) D : market value of debt r D : required return on debt E L : market value of levered equity r E : required return on levered equity Unlevered firm (U) : a firm with no debt (or an all-equity firm) V U : total market value of an unlevered firm ( V U = E U ) E U : market value of unlevered equity r U : required return on unlevered equity, also called required return on the firm’s assets ( r A ) Lecture 5: MM Propositions
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Case I: M&M without corporate taxes (1958) No corporate taxes Remember that, if there are no corporate taxes, levered FCFs = unlevered FCFs (i.e. DTS = 0) No bankruptcy costs For convenience, assume that debt is risk-free (i.e. zero probability of default), so the cost of debt equals the risk- free rate 11 Lecture 5: MM Propositions
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M&M without taxes Do capital structure choices affect a firm’s value? MM1 Do capital structure choices affect a firm’s cost of capital? MM2 Lecture 5: MM Propositions 12
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13 Modigliani-Miller Propositions (No Taxes) Assumption of perfect capital markets Investors & firms can trade the same securities at competitive market prices (e.g., can borrow and lend at same interest rate) No taxes , transaction costs, or issuance costs No bankruptcy costs Firms and individuals have the same information. Setting: Two firms, L and U , are identical in operations, but different in capital structure: L is levered (perpetual debt) and U is all equity. U and L give the same perpetual random cash flow with mean C . Both will pay out all cash flow after interest as a dividend. Lecture 5: MM Propositions
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14 Modigliani-Miller Propositions MM 1 (no taxes): V L = V U o Meaning: the choice of capital structure does not affect firm value, that is, capital structure is irrelevant. o Key intuition: changing the capital structure does not affect the firm’s cash flows or cost of capital of the firm’s assets. MM 2 (no taxes): o Meaning: the required return on levered equity is increasing in financial leverage.
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