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Flashcards in Chapter 17 Deck (23):

Role of financial manager? M&M point?

Role: find combination of securities that maximises firm's value
MMP1: When firm pays no taxes and capital market function well, makes no difference if firm borrows or if individual SHs do tf MV not dependent on a firm's capital structure


If a firm is unlevered?

E=V (D=0)


If a firm issues only one type of security rather than 2, they decrease investors choice; when doesn't this then reduce firm value?

a) if investors don't need/want choice
b) if alternative securities are available


See notes

From 'assumption' down to end of example, check i know how to do it aswell


What is the law of one price?

In efficient markets, 2 investments with equal payoffs must have the same price (see next example in book?)


M&MsP1? What law does this lead to?

The MV of any firm is independent of its capital structure

Leads to the Law of Conversion of Value:
The value of an asset is preserved regardless of the nature of claims against it


Alternative way of stating M&MsP1?

Firm value is determined by the LHS of the balance sheet, by real assets, not by the proportion of debt and equity securities issued to buy assets (also applies to mix of debt securities issued (eg. secured vs unsecured))


See page 441

An example to illustrate MMP1 and reasoning (v important)



Main points bit at bottom of CH17 page 1 side 1 also v important i understand and can explain it!


Summary of the 'main points' bit? (2)

Firm value is independent of debt ratio because, although leverage can increase the expected stream of EPS it can't increase the share price. This is because the change in expected earnings stream is EXACTLY OFFSET by the rate at which earnings are discounted


See and understand

Example showing a firm's borrowing decision doesn't affect the firm's expected return on assets


The expected return on a portfolio is equal to...

the weighted average of the expected return on all its holdings
the company cost of capital/the weighted average cost of capital (WACC)


What is MMs proposition 2?

The expected rate of return on the common stock of a levered firm depends on:
-The proportion of the debt-equity ratio
-The spread between r(a) and r(d) (expected rates of return)



Macbeth example page 2 of notes and in books now


How do debt levels affect the amount investors demand as compensation? Why then, using MM1 and MM2, are SHs indifferent to increased leverage when it increases expected return?

When firm is unlevered investors demand r(a), when it borrows the investors demand a premium of (r(a)-r(d)).D/E to compensate for the extra risk

BUT any increase in expected return is exactly offset by an increase in financial risk and tf in SHs required rate of return (page 444 example 17.1 and in notes)


Why do equityholders require a higher rate of return when a firm leverages up?

The financial risk rises for an equityholder when the firm borrows more since it means if the firm goes under, they will have more money to repay to creditors before they get to repaying equityholders tf is less likely they will get repaid



Page 446 and example 17.2 447


Draw and entirely explain the WACC diagram?

Check i know it all!!!!!!!!!!


2 points regarding if MMs P1 holds?

if it holds:
'maximise overall MV' is equivalent to 'minimise the WACC'
if it doesn't hold, BUT operating income is independent of capital structure, they are still equivalent


Draw and entirely explain the WACC TRADITIONAL VIEW diagram?

see notes


2 arguments that support the WACC traditional view?

1) SHs don't notice/appreciate financial risk from moderate borrowing, but 'wake up' when debt is excessive
2) MM's reasoning applies to perfect capital markets but in reality markets aren't perfect!



pages 450 and 451 and see union pacific example and slides


Explain how a tax shield affects the after-tax WACC? and draw the diagram showing this?

If a firm receives a tax shield on interest payments, then after-tax WACC declines as debt increases (see notes)