Chapter 14 - Capital structure in a perfect market Flashcards
When a firm needs to raise funds to fund an activity or project, what does it need to do?
The firm needs to consider what kind of security it should use to raise the funds, and what combination. Are we talking all-equity, all-debt, combinaiton of both?
Define perfect capital markets
Perfect markets are defined as:
- All securities are fairly priced
- no taxes or transaction costs
- Total cash flow from a project is not affected by how the firm choose to finance it.
define capital structure
Capital structure refers to the proportions of hte firm that is financed through equity, debt and other securities
if a projects returns depend on the overall movement of the economy, what can we say about it?
THe project contains market risk. An outcome of market risk is that investors will require a premium to offset the risk.
In the absence of arbitrage, what is the price of a security?
In general, the value of its cash flows. present value, that is.
equity in a firm with no debt is called…?
unlevered equity
equity in a firm that has debt outstanding is called..?
levered equity.
if economy is strong, a project delivers 1400 usd.
if weak: 900 bucks.
The project requires 800 bucks initially.
If 500 is funded with debt at 5%, what will equity holders be payed?
Equity holders are payed after debt holders.
500 x 1.05 = 525
strong: 1400 - 525 = 875
weak: 900 - 525 = 375
What price should levered equity sell for?
What capital structure is best for the project?
In perfect capital markets, the total value of a firm does not depend on its capital structure. Why?
The cash flows that the project generates will be the same as the cash flows of the firm.
the law of one price then say that the price of the securities in the firm must equal the “total package” of debt+equity financing of the project. if this was not the case, then an investor could utilize the opportunity to gain arbitrage money.
So, if the cash flows generated is equal to 1000 in present value, then the cost of the equity and the debt must together be worth 1000. Therefore, if the project financed 500 worth through the use of debt, then the value of hte equity is simply 1000 - 500 = 500.
There is something important that results from considering levered equity. Elaborate
The value of the firm (or project’s) equity is less when using debt to finance a part of it. Why is this the case?
Equity is worth less now because a part of the cash flows that are generated by the project must go to the creditor.
Changing capital structure is a change in cash flow distribution.
How does the capital structure (in perfect capital markets) affect the decision of the project owner?
It does not affect him. He will be able to raise the money he needs regardless of the equity-debt split. This is because of the law of one price.
Assuming perfect capital markets include assuming no arbitrage. If no arbitrage exists, then we know that if the firm generates X dollars in cash flows, then the price of the firm’s equity AND the debt must be equal. Otherwise, an investor could buy one of them and sell the other etc.
The traditional view was that the value of the levered equity would exceed 500 because:
(0.5 x 875 + 0.5 x 375 ) / 1.15 = 543, meaning that the expected value of the returns of the investment in the firms levered equity is greater than 500.
Why is this not correct?
It is about the cost of capital.
15% represent 5% risk free rate and a risk premium of 10% from the all-equity variant.
The equity is levered, which means that the expected returns that follow from it is partly because of the debt.
Investor that invest in levered equity require a larger risk premium.
This reason the levered equity is more risky than the unlevered equity, is because of how a proportion of the cash flows generated by the project MUST be allocated to the creditors before equity holders receive anything. Therefore, a project that would be NPV positive regardless of outcomes when unlevered through all-equity, could actually very fast become negative NPV because of the fixed sum required by the debt issuer.
also, consider what happens in the case of default. All return are given to creditors, nothing to equity holders.
The additional risk of buying levered equity will increase the risk premium demanded by the equity investors. Because of this, we cannot use the “unlevered cost of capital” to discount the cash flow. We must use a rate that will be higher, as it needs to accommodate for the larger risk.
CASE:
CFO needs to raise 1000 bucks for a project. Assume the project is all the firm is undertaking.
If economy is strong, the project generates a cash flow of 1400 bucks. If weak: 900 bucks.
Equally likely to happen.
He choose to raise 500 through debt at the risk free rate of 5%. The remaining is equity.
What is the risk premium that the investors of equity will demand for holding equity in this project/firm?
The money that the creditors require regardless of the result, is 500 x 1.05 = 525 bucks.
The remaining cash flow is therefore either:
1) 875
2) 375
The price of the equity is 1000 - 500 = 500.
Why? The initial value of 1000 bucks must be equal to the cash flows that are generated by the project, because of the law of one price. If not, investors would have an aribtrage opportunity, which is assumed to not exist in perfect capital markets.
Since the capital sturcture worth of debt is 500, we know that the remainign is 500. Therefore, equity is worth 500.
IF the firms project was all equity (unlevered), we would have gotten the following properties of teh equity:
1) expected return 1400x0.5 + 900x0.5 / 1000 = 15%.
2) if economy is strong, equity holders would get 40% returns.
3) If economy is weak, equity holders would get -10% returns.
If the firms project is financed thorugh 500 usd (50%) worth of debt, the following properties arise for equity holders:
1) expected return: (875x0.5 + 375x0.5)/500 = 25%.
2) if economy is strong: 875/500 = 75% returns.
3) if economy is weak: 375/500 = negative 25%.
The risk premium is 20%, vs the 10% for the unlevered equity.
This case shows how the returns of the equity are effected by the capital structure.
However, in terms of the project and the cash flows of the project as a whole, the fund raising procedure does not matter at all. Of course, the project owner typically has equity and will be affected, but the cash flows generated by the project are not affected.
true or false?:
leverage increases the risk of equity even when there is no risk of default
true.
The leverage will increase the fluctuations in return on the equity, and therefore the risk of equity.
When we are talking about “return sensitivity” what are we tlaking about?
The difference between max and min returns, in percentage terms.
For instance, if the project will either return 75% or -25%, the return sensitiivty is 75 - (-25%) = 100%
The law of one price says that leverage will not affect the total value of the firm. What does the law say that leverage affect?
The allocation of the firms cash flows. It does not alter the amount of cash flow generated by the project, only the split between equity and debt in terms of allocating the project flows.
Modigliani and Miller showed that the capital structure independence etc holds under “perfect capital markets”. What are perfect capital markets?
Defined by 3 assumptions or conditions:
1) Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.
2) There are no taxes, transition costs, issuance costs, associated with security trading.
3) A firms financing decisions does not change the cash flows generated by its investments, nor do they reveal new information about them.
What is MM-proposition 1?
Under the conditions of perfect capital markets, the total value of a firms securities is equal to the market value of the total amount of cash flows generated by the firms assets, and is not affected by its capital structure.
NB: the firms securities include their equity and their debt.
elaborate on what investors can do if they dont like the capital structure of a firm they want to invest in
They can engage in homemade leverage.
Homemade leverage is about borrowing money at your own wish so that you leverage yourself, and invest your leveraged equity into the firm. This makes you increase the risk.
if the investor want less debt in the capital structure, he can simply buy the debt and the equity of the firm.
Elaborate on the market value balance sheet of the form
Similar to accounting balance sheet with 2 major distincitons:
1) All assets and liabilities of the firm are included. Even intangibles.
2) All values are current market values, rather than historical cost.
On the market balance sheet, the total value of the firms securities must equal the total value of its assets.
How do we calculate market value of equity?
Market value of equity = market value of assets - market value of debt
What is a leveraged recapitalization?
A leveraged recapitalization refer to the case where a firm use leverage (debt) to re purchase shares that is outstanding and not owned by the firm.
A leveraged recapiatlization can be regarded as a two step process:
1) the firm sells debt to raise a sum of money, like 80 million usd.
2) The firm use the cash, including the cash raised by debt, to re purchase shares.
how does zero NPV transactions affect share price?
No effect. Only changes in net present value of the firm can change share price.
Does a leveraged repurchase change share price?
No. Such an action is a zero NPV transaction.
A firm will first borrow say 80 million, and spend 80 million to repurchase shares.
Assets, which equals to liabilities + equity, will first increase with the cash borrowed, and then decrease again because the cash is used to buy shares.
The result is “80 million borrowed cash in, 80 million cash out, equity in”.
The firm gain 80 million in value because of the additional shares, but it also decreased 80 million in value because it borrowed 80 million.
The firm will now have to pay creditors a proportion of their cash flow.
The market cap (market value of equity) will decrease because the number of shares outstanding will be reduced, and the share price remains that same (because zero NPV transaction).
I think maybe the price remains the same if the repurchase happen at this price. Under such circumstances, we keep the ratio of market cap/shares the same, which cause the share price to remain the same.