Ch 17: Capital Structure in a Perfect Market Flashcards
(34 cards)
In a perfect capital market, does capital structure affect firm value?
No. Capital structure does not affect the value of the firm in a perfect capital market.
What are the assumptions of a perfect capital market?
No taxes, no transaction costs, symmetric information, and rational investors.
What does Modigliani and Miller Proposition I state?
The total value of a firm is independent of its capital structure.
What is the Law of One Price in MM Proposition I?
Two assets with identical future cash flows must have the same value.
What is homemade leverage?
When investors borrow on their own to replicate the risk/return of a levered firm.
Why does homemade leverage support MM Proposition I?
Because investors can adjust leverage themselves, so firm leverage doesn’t create value.
What does MM Proposition II say about cost of equity?
Cost of equity increases with leverage due to higher financial risk.
Give the MM Proposition II formula for cost of equity.
rE = rU + (D/E)(rU - rD)
What is WACC?
Weighted Average Cost of Capital, the average return required by all capital providers.
What is the WACC formula in a no-tax setting?
WACC = (E/(E+D)) * rE + (D/(E+D)) * rD
Why doesn’t WACC change with leverage in a perfect market?
Because the increase in equity risk offsets the benefit of cheaper debt.
What is asset beta?
It measures the risk of the firm’s business operations, not affected by capital structure.
What is equity beta?
It measures the risk borne by shareholders, which increases with leverage.
Why is equity beta higher with more leverage?
Because equity holders bear more residual risk after debt obligations are paid.
When can asset beta be greater than equity beta?
When the firm has negative net debt, excess cash lowers equity risk.
Give the formula to calculate equity beta from asset beta.
βE = βU + (D/E)(βU - βD)
Give the formula to calculate asset beta from equity and debt betas.
βU = (E/(D+E)) * βE + (D/(D+E)) * βD
What is net debt?
Net debt = Total debt - Cash and short-term investments.
How does negative net debt affect equity beta?
It reduces equity beta because the excess cash lowers overall risk.
How does positive net debt affect equity beta?
It increases equity beta due to more financial risk for shareholders.
Why is it incorrect to assume higher EPS leads to higher stock price when we increase leverage?
Because higher EPS often comes with higher risk; risk must also be considered.
What is the fallacy in assuming new share issuance always leaves share price unchanged? despite the answer being true the answer doesn’t state the fallacy as mentioned in the slides
If shares are issued below fair value, it dilutes existing shareholders’ value.
Catchphrase: Debt and equity financing equivalence
“It’s not how you slice the pie, it’s how big the pie is.”
Catchphrase: Effect of debt on equity
“Debt makes equity edgy.”
