term 2 lecture 5 - capital structure Flashcards
what are the two ways firms can finance their operations?
firms finance their operations through retained earnings (internal financing) and through selling securities in capital markets (external financing)
what are external funds for investment exchanged for ?
they are provided by investors in exchange for claims on the firms future cash flows
what are the methods of external financing?
issuing debt
issuing equity
issuing hybrid securities such as convertible debt, preffered stocks etc
what are the different claims on the future cash flows of the company between debt and equity ?
division of value: debt holders are entitled to fixed payments for a specified time period (debt has seniority over equity). equity holders are entitled to the future residual earnings of the firm (they get the funds remaining after the debt has been paid off)
division of control : equity holders have voting rights and control the firm (as long as the firm can service its debt)
for investors, what is the required rate of return equivalent to?
the opportunity cost of investing their money elsewhere (in investment opportunities with a similiar risk)
what is the capital structure?
the firms relative mix of debt and equity?
what is financial leverage or gearing?
the firms ratio of febt to total financing
what is a levered firm>?
a corporation that has debt outstanding
what is an unlevered firm?
a corporation without debt in its capital structure is reffered to as an unlevered firm
what theorems form the basis of the modern capital structure theory?
the moodigliani miller theorems ( MM theorems)
what are the MM assumptions?
1) perfect financial markets - securities are fairly priced (equal to PV of their future cash flows). no transaction or issuance costs
2) financing decisions do not: change the cash flows of the investments. reveal new information about cash flows
3) all agents have the same information (can trade the same set of securities)
4) unlimited borrowing and lending at risk free rate
5) no bankruptcy costs
6) no taxes
what is the first proposition of the MM theorems?
the total value of a firm is equal to the market value of the total cash flows generated by its assets
the total value of a firm is not affected by the firms choice of capital structure
what is the formula for the market value of a firm?
what is the framework for the model for the MM proposition 1?
there are 2 firms, 1 has all equity the otther has debt and equity. V1 = value of firm 1 and V2 is the value of firm 2. S1 is the total outstanding stock of firm S2 is the total outstanding stock of firm
D2 is te outstanding debt of firm 2 and r is the risk free rate X is the expected return which is the same for both firms under homogeneity assumption
what occurs when V2 > V1 for the MM model?
what occurs when V1>V2?
does the firm value depend on the capital structure?
Modigliani and Miller showed that that the firms value does not depend on the capital structure
what is homemade leverage?
when investors use leverage in their own portfolio (borrow), we can say that they are using homemade leverage. as long as investors can borrow or lend at the same interest rate as the firm, homemade leverage is a perfect substitute for firms leverage
what is the MM proposition 2?
with leverage, equity is riskier and the shareholders required rate of return increases
what is the rate of return
the rate of return is the return to an unlevered firm plus a risk premium based upon leverage. the higher the leverage, the higher the return.
what is the implications of perfect capital markets with MM?
what is the risk premium on debt>
the risk premium on debt is zero because debt return bears no systemic risk
what is the impact of leverage on risk?
the leverage increases the risk of the equity of a firm. investors in levered equity will require a higher expected return to compensate for the increased risk. due to the greater risk, the discount factor will be greater for leveraged equity
how does the law of on price impact the value of debt and equity?
Modigliani and Miller argue that with perfect
capital markets, the total value of a firm should not
depend on its capital structure.
they reason that the firms total cash flows still equal the cash flows of the project. Because the cash flows of the debt and equity sum
to the cash flows of the project, by the Law of One
Price.
how can the relationship between risk and return be evaluated more formally?
by computing the sensititivity of each security return to the systemic risk of the economy:
