Capital Structure in a Perfect Market Flashcards
What is the definition of capital structure?
The relative proportions of debt, equity and other securities that a firm has outstanding
What is unlevered equity?
-Equity in a firm with no debt
-Cash flows are equal to those of the project
What is levered equity?
-Equity in a firm that also had debt
-Creditors are above equity holders in the waterfall, so get paid first
-Debt is risk free
What are two key takeaways from debt+equity financing?
-Total value of a firm does not depend on its capital structure
-The cash flows from debt and equity = cash flows from unlevered equity
What is the relationship between leverage and risk?
-Leverage increases the risk of equity even when there is no chance of default
-Therefore, debt raises the cost of capital
What is the relationship between the average cost of capital and leverage?
-Average cost of capital is the weighted average of debt and levered equity which is the same as the unlevered cost of capital
What is MM Proposition 1?
In a perfect capital market, the total value of a firm’s securities is equal to the market value of the total cash flows generated by its assets and is not affected by its capital structure
What are the characteristics of perfect capital markets?
-Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows
-No taxes, transaction costs of issuance costs
-A firm’s financing decisions do not cahnge the cash flows generated by its investments nor do they reveal new information about them
How does MM relate to the Law of One Price?
-Total cash flow to security holders = total cash flow generated by the firm’s assets
-Firm’s securities = Firm’s assets
-Therefore, as long as financing does not change cash flows, it will not affect the value of the firm
-Therefore, there is no net gain or loss from leverage
What is homemade leverage?
-Investors leverage their own portfolios to adjust the leverage choices made by a firm
-This is a substitute as long as investors can borrow or lend at the same interest rate as teh firm
What are the key characteristics of the market value balance sheet?
-All assets and liabilities are included
-All values are current market values not historical costs
-Total value of all securities = total value of assets
-Market Value of Equity = Market Value of Assets - Market Value of Debt and Other Liabilities
What is leveraged recapitalisation?
-Share repurchases financed by issuing new debt
-Debt decreases the equity of the firm by the same amount of the shares repurchased
-No change in share price
-Assets = Market Cap of firm
What is MM Proposition 2?
-The cost of capital of levered equity increases with the firm\s market debt-to-equity ratio
-Market Value of Levered Equity + Market Value of Debt = Market Value of Unlevered Equity = Market Value of Assets
-(E/E+D) RE+ (D/E+D)RD= RU
-RE= RU- (D/E)(RU-RD)
What is the relationship between capital structure and WACC in perfect capital markets?
-The WACC is independent of a firm’s capital structure
-WACC= unlevered equity cost of capital= asset cost of capital
How does a firm’s equity beta change with leverage?
It increases
What is the relationship between EPS and leverage?
No increase with an increase in leverage
Is dilution a feasible concept?
-No
-Issuing new shares is accompanied by cash inflows
-As long as a firm sells new shares of equity at a fair price, there will be no gain or loss for shareholders associated with the equity itself
What is the conservation of value principle?
-With perfect capital markets, financial transactions neither add nor destroy value
-Financial transactions represent a repackaging of risk and return
-Any gain made is due to exploitation of any market imperfections
