Chapter 14 - Capital structure in perfect markets Flashcards
What is capital structure and what is its meaning?
Capital structure refer to the issued equity, debt and other securities of a firm.
The meaning behind capital structure is to raise funds.
The other meaning behind capital structure is to hold a strategic mix that increase profits in the long run, for instance tax shields.
a firm needs funds to start a new project. Ultimately, what determines the choice of capital structure?
The effect that the capital structure has on the NPV of the expansions.
What choices do we typically consider when raising funds?
Raise funds by issuing equity.
Raise funds by borrowing money.
In perfect capital markets, what is the effect of the law of one price in regards to choice of capital structure?
Should not matter.
what is the beta here?
Beta of 1 due to how the project has two states, and the economy has two states, and they swing together
How much would investors be willing to pay for the equity in this project, given that it is all-equity financed?
we know that the law of one price say that the price is equal to the cash generated by the assets in this case, since no cash from the asseets are allocated to creditors.
Therefore, investors view the project liek this: if I invest in it, how much do I get back?
The project leaders view: I need X money to start it, and I will get Y in return.
From the perspective of the investor, the assets generate expected value $1150.
We discount using the cost of capital: 15% –> present value of $1000.
Since the project’s assets generate cash flow worth $1000, this is the price for the entire equity of the project.
Now, since the owner of the project only need $800 to fund it, he essentially receives $200. This is the project’s NPV. This illustrate how the current owners of the firm receives this additional value if the firm initiate a new NPV positive project.
What do we call equity in a firm that has no debt?
unlevered equity
In our simple world, when can we say that using debt to raise funds is risk free?
If we know that the project will always generate cash flows that can pay the debt, then the debt is risk free.
What do we call equity in a firm that has outstanding debt?
Levered equity.
What is important regarding levered equity?
Payments to debt holder must take place before payment to equity holders.
Suppose the firm decides to borrow 500. What happens in the various scenarios, given interest of 5%.
Strong economy: 1400 up, less the 525 we owe the debt holders = $875.
Weak economy: 900 up, less 525 we owe, = $375.
notice how the debt holders receive the same cash regardless.
Equity holders are significantly more fucked though, if the economy is weak.
We need to raise 800, and 500 is through debt, which require 300 from equity.
The question then becomes : What should the levered equity sell for?
According to Modigliani and Miller, what should the levered equity sell for?
According to them, in perfect capital markets, the total value of the firm should not depend on capital structure. Their reasoning is that the same underlying assets still generate the same cash flows, and this is what we use to find present value.
The only differnece is how much of the cash flows that are being sent to debt holders and how much of it is being sent to equity holders.
If the assets generate $1000 in presnet value, then this is the total value of the firm. If the value of debt is 500, the value of the equity must be equal to 500 as well.
equity is less valuable when a portion is financed through debt, vs when it is all equity (naturally) because the assets generate hte same cash flows. How does this affect existing owners of the project?
It doesnt. He will raise $1000, but hte cost is only $800.
Why is this wrong?
It is wrong because it discount using only equity cost of capital.
The reason for this is that the levered equity makes it more risky, which means that we need to use a different discount rate
Why is levered equity more risky than unlevered equity+
Levered equity is more risky because the effect leverage has on equity holders is relatively bigger than all equity. So that if the project suffer a little bit, equity holders are more fucked if there is a debt part there compared to as if the debt part is not there.
Recall from the example: All equity: 1400 or 900. Debt+equity mix: 875 or 375. Since the debt is worht 500, and the project value is
elaborate on the argument of capital structure made by Modigliani and Miller
They argued that in perfect capital markets, the choice of capital structure does not matter. their reasoning is that the underlying assets still produce the very same cash flows. By the law of one price, the cash flows produced by the assets (present value) must equal to the total price of them, regardless of whether they are all equity, or debt and equity.
elaborate on the effect that levered equity has on equity holder’s demand
levered equity is more risky than unlevered equity. This is because the use of equity will amplify the returns in either case/outcome.
For instance, say some assets of a project will generate $1400 if economy is strong, and $900 if economy is weak.
If we do all-equity, we can find the expected value, which is $1150, and then use CAPM to find the required return. Since the project follow the economy in a binary way, it is correlated, and we use beta of 1.
required return = rf + beta(E[Rmkt] - rf) = 5% + 1(10%) = 15%
Then we would discount using 15%: 1150/1.15 = $1000
This means, when using all equity to finance the project, the equity is equal to $1000.
Then let us consider the mix of debt and equity. We borrow $500 at the risk free rate.
We can consider the debt risk free since we know we can repay it regardless.
Since 500 is done thourhg debt, there are 500 remainig that must be funded through equity.
Let us consider cash flows:
Strong economy: Debt holders receive $525. Equity holders receive $875.
Weak economy: Debt holders receive $525. Equity holders receive $375.
HOWEVER: The equity holders originally purchased the equity for $500, because this is what the value the assets produce is. the value is equal regardless of capital structure. recall why this is. (arbitrage).
Therefore, we can see that one outcome is positive, and the other is actually negative. The returns are now amplified.
All-equity had returns of 1400/1000 = 40% and 900/1000 = -10% with expected returns of 15%.
debt-equity mix has returns of (equity perspective) 875/500 = 75%, and 375/500 = -25%, with expected value 25%.
This example highlights the fact that when using debt, the EQUITY (levered equity) becomes risky. And since the levered equity is more risky, equity holders will demand a larger expected return to compensate.
what is homemade leverage?
Homemade leverage refers to the case where an investor wants to buy a share in a firm, but is not happy with their dbet situauiton, and create more leverage by investing more in the firm using margin. This way, he can amplify his returns the same way as if the firm did it.
This is shown on the image. We can see how the original position is all equity, and cost 1000. However, the investor borrow 500 and use 500 of his own equity. This create the same old split as before. the difference is that now, the investor is the one who must pay the creditors the 525 before he gets the slice. This is virtually the exact same situaiton as if the firm used leverage,
Say a firm use a mix of equity and debt (levered equity). As an investor, we want ot buy, but we do not want the added risk of the levered equity. What do we do?
We purcahse the total firm, meaning that instead of only buying equity, we buy the debt as well. this will make us have a claim to the entire cash flow.
Consider this equation. what is the additional risk compensaiton that follow from using debt?
We can find it by sovling for equiry returns:
Re = (Ru - D/(E+D)Rd)(E+D)/E
Re = Ru(E+D)/E - Rd (D/E)
Re = RuE/E + RuD/E - Rd(D/E)
Re = Ru + D/E (Ru - Rd)
Here we can see that the required return from the equity is equal to the unlevered return plus the debt-equity ratio multilplied by the differnece in returns from teh unlevered and the debt
