33.2.1: Capital Structure Flashcards
Operating leverage = …
Operating leverage = Fixed costs/Total costs
After-tax cost of debt = …
After-tax cost of debt = Before-tax cost of debt × (1 − marginal tax rate)
Modigliani–Miller Propositions state?
MM argued that, given certain assumptions, managers cannot change firm value simply by changing the company’s capital structure.
What does the MM Proposition I without Taxes: Capital Structure Irrelevance state?
The market value of a company is not affected by the company’s capital structure.
What does MM Proposition II without taxes tells us about?
That adding any amount of lower-cost debt capital to the capital structure is always perfectly offset by an increase in the cost of equity, resulting in no change to the company’s overall weighted average cost of capital.
MM Proposition II without taxes tells us that …
A company’s cost of equity is a linear function of its debt-to-equity ratio.
A company’s cost of equity is a linear function of its debt-to-equity ratio.
*MM Proposition II without taxes
Re = r0 + (r0 − rd)D/E
Where:
- re is the cost of equity,
- ro is the cost of capital for a company financed only with equity (i.e., an all-equity company),
- rd is the cost of debt,
- D is the market value of debt,
- E is the market value of equity.
Modigliani and Miller’s Proposition I with corporate taxes states that …
In the presence of corporate taxes (but not personal taxes), the value of the levered company is greater than that of the all-equity company.
Modigliani and Miller’s Proposition I with corporate taxes formula is …
VL = VU + tD
Where:
- t is the marginal tax rate
- tD is the present value of the debt tax shield.
MM Propositions with Taxes: Cost of Capital formula is …
Re = r0 + (r0 − rd)(1 − t)D/E
The beta (or systematic risk) of a company’s assets as a weighted average of the systematic risks of its sources of capital formula is …
βe = βa + (βa − βd)(D/E)
Where:
- βa is the asset’s systematic risk, or asset beta,
- βd is the beta of debt,
βe is the equity beta.
