capital strcture in a world of perfect markets Flashcards
what did Modigliani and Miller show
that in a world of perfect capital markets, the choice of capital structure is irrelevant for the valuation of a firm
because the cash flows generated by the firm’s investments are unchanged when the firm has a different capital structure
- since the value of a company is calculated as the present value of future cash flows, the capital structure cannot affect it
- cash flows are now just allocated differently between the equity and debt holders
what is MM proposition 1 and what does it show
the value of a levered firm = the value of unlevered firm
- levered firm = financed by both equity and debt
- unlevered = equity financed firm
shows that it didnt matter if an equity investor preferred a different capital structure to the one the firm chose
- investors can create their own degree of leverage (homemade leverage)
- if they prefer an alternative capital structure to the firms one, they can borrow/ lend on their own and achieve the same results
- homemade leverage = perfect substitute for firm leverage in perfect capital markets
what is the cost of capital fallacy
there are certain situations where one firm would think to finance itself only with debt (like its cheaper) but
- debt is riskier than equity for the company
- it involves a contractual obligation to pay interest and repay principal
- if cannot meet this obligation - it is declared bankrupt
- the more debt it takes on = greater risk of bankruptcy
- greater risk of bankruptcy = affect equity investors
- equity investors rank below debt holders in the event of bankruptcy when it comes to repayment of their claim
- increase in debt by the company = equity investors increase the required return to compensate for the greater risk
- levered cost of equity increases
- equity doesn’t have this legal obligation
what is the company cost of capital in a frictionless world
it is independent of leverage and always equal to the unlevered cost of capital
what is MM proposition 2
the cost of equity of a levered firm increases in proportion to the debt equity ratio
or
the cost of capital of levered equity = the cost of capital of unlevered equity plus a premium that is proportional to the ratio of debt to equity
is earnings per share a useful performance metric
EPS = net income / shares outstanding
- useful metric for evaluating a company’s profitability on a per-share basis
