Capital Structure Flashcards
contains M-M theorem (22 cards)
Capital structure theory example?
Modigliani-Miller theorem
what is the key question capital structure theory presents?
is there a combination of equity and debt which maximises the value of a firm?
who and when was the M&M theory developed?
Franco Modigliani and Merton Miller 1958
In a perfect world what does the M&M theorem assume?
no taxes, no chance of bankruptcy, perfectly efficient markets and symmetric information sets for all participants
M&M perfect world (MMPW) what does it state?
states that the capital structure of a company does not affect its overall value
MMPW Proposition 1 equation?
Vl = Vu, which is value of a leveraged firm is equal to the value of an unleveraged firm (e.g: an all-equity financed firm)
MMPW Proposition 2?
cost of equity increases with firm’s leverage (debt/equity ratio)
MMPW Proposition 2 equation?
iE = iE,0 + D/E (iE,0 - iD), where iE and iD is the value of equity and debt of a leveraged firm and iE,0 is the cost of capital for an unleveraged firm
MMPW what is the effect of leverage on cost of equity?
cost of equity (iE) increases with the firm’s leverage (D/E). This is because, as leverage increases, shareholders bear more risk, thus they require higher compensation (such as return) to hold that risk
what does WACC mean?
weighted average cost of capital
MMPW what is the effect of leverage on WACC?
equity becomes more expensive, however debt has a lower required rate of return than equity so is less risky from an investor’s perspective. As leverage increases the lower proportion of expensive equity is offset by a higher proportion of cheaper debt. WACC will remain the same. This is why in M&M’s perfect world capital struct has no impact on firm value
what are the M&M with corporate taxes (MMCT) assumptions?
corporations are taxed, corporate debt is perpetual, interest is tax deductible, firms are able to take advantage of any interest tax shields
MMCT proposition 1? what does it change to (from PW to CT)?
Vl = Vu +DTc, where Vl is value of leveraged firm, Vu is value of unleveraged firm, D is the value of debt and Tc is the tax rate
MMCT what should be done for an optimal capital structure?
So, for an optimal capital structure firms should use 100% debt
MMCT proposition 2? what does it change to (from PW to CT)?
iE = iE,0 + D/E (iE,0 - iD)(1 - Tc)
What does MMCT proposition 2 mean?
The cost of equity will still increase with the leverage level. But the presence of tax shields affects the relationship by making the cost of equity less sensitive to the leverage level. So WACC decreases as leverage increases
M&M with Corporate Taxes and Bankruptcy (MMCTB) intro?
Further relax the “perfect world” assumptions by allowing the possibility of the firm going bankrupt. Being close to bankruptcy can result in costs of financial distress that start affecting the firm value. Debt becomes riskier therefore lenders demand higher compensation in return. Shareholders also start to worry about losing money
Financial distress costs include?
loss of consumer and supplier confidence, may face tighter credit terms offered by suppliers, declining partnership opportunities with other firms and potential loss of better employees
MMCTB proposition 1 what is it?
Optimal Debt/Equity ratio depends upon tax rate and financial distress costs due to debt
MMCTB proposition 1 equation?
Vl = Vu + DTc - costs of financial distress
M-M Theorem vs reality: according to the theory what 2 main factors affect firm’s capital structure?
Tax effect and bankruptcy risk
M-M Theorem vs reality: who conducted what research and when? according to research from reality what 2 main factors affect firm’s capital structure?
Graham and Harvey (2001) conducted a survey and collected results from 392 CFOs. Top 2: financial flexibility and credit rating
