Debt Policy Flashcards
Financial Leverage
The uses debt as an attempt to increase the returns to equity.
Capital Structure
a firms’ mix of debt and equity financing.
Use of leverage to increase stock returns
the firm borrows and invests in assets that have a rate of return greater than the interest on the loan (effectively and +NPV)- real value of the firm increases
Modigliani-Miller approach 1
Imagine that the financial manager would like to find the combination of securities that maximizes the value of the firm. MM’s answer the financial manager should stop worrying.
Modigliani-Miller approach 2
In a perfect market, any combination of securities is as good as another. The value of the firm is unaffected by its choice of capital structure.
Modigliani-Miller approach 3
Consider two firms that generate the same stream of operating income (or cash flows).
These firms differ in their capital structure:
Firm U does not have any debt and, as a result, the value of its equity is equal to the value of the firm (unlettered firm). Eu =Vu
Firm L is levered and the total value of its equity equals the value of the firm less the value of its debt (levered firm). El= Vl -Dl
Questions rises which to invest in?
MM Scenario 1:
You decide to buy 1% of firm U. You pay 0.01 x Vu and in return, you claim 1% of the firm’s profits (risk-averse).
MM Scenario 1: continued
Alternatively, you may decide to buy 1% of both equity and debt of firm L (diversify). In this case, 0.01xEl +0.01xDl, and you have a claim of, 1% of the firm’s net profits (profits less interest payments on debt)
MM Scenario 1: continued 2
Both strategies offer the same return on our investment, equal to 1% of profits. The absence of arbitrage opportunities means that strategies with the same return should have the same cost.
The law of one price tells us that:
in the efficient/well-functioning markets, two investments that offer the same payoff must have the same price
The value of the unlettered firm must equal the value of the levered firm.
MM Scenario 2:
You decide to buy 1% of firm L. You pay 0.01xEl and in return, you claim 1% of the firm’s net profits (relatively less risk-averse).
Alternatively, you may decide to borrow an amount equal to 0.01xDl and purchase 1% of firm U (diversify).
In this case, you have a claim of 1% of the profits of firm U. But you have to pay interest on your debt.
MM Scenario 2: 2
Both strategies offer the same return on our investment, equal to 1% of interest payments. In efficient markets the absence of arbitrage opportunities means that strategies with the same return (0.01x(profits-interest)) should have the same cost/price. The value of the unlevered firm is equal to the value of the levered firm.
MM proportion I:
The market value of any firm is independent of its capital structure. Firm value and therefore shareholders’ wealth is not determined by its capital structure. Firm value is determined on the left-hand side of the balance sheet, by real assets and not by the proportions of debt and equity securities issued to buy the assets.
MM assumptions 1
- competitive markets: individuals can borrow and lend at the same rate, individuals can borrow at the same interest rate as firms.
- efficient markets: complete and symmetric information there are no arbitrages opportunities.
MM assumptions 2
absence of taxation: in reality interest payments are tax deductible (contrary to dividends). Levered firms can reduce overall tax obligations (advantages on leverage) differential taxation on dividends and payments from bonds.
MM assumptions 3
absence of bankruptcy costs
investment opportunities unaffected by financing decisions.