Topic 2 Capital Structure I: Perfect Capital Markets- Modigliani and MIller

Question 1

Takeaway of MM in Perfect Markets

Answer 1

-Whenever investors can undo a decision made by the firm, then that decision does not change the value of the firm
-The equity becomes riskier and the cost of equity increases however the cost of the firm’s assets remains unchanged

Question 2

MM Prop I

Answer 2

Total value of a firm’s securities is equal to the market value of the total cash flow generated by its assets and it is not affected by its choice of capital structure

Question 3

3 key assumptions of MM Prop I

Answer 3

1) assumptions of perfect capital markets
2) Concept of homemade leverage
3) concept of market value balance sheet

Question 4

Perfect Markets Assumptions

Answer 4

Competitive markets where firms and individuals buy/sell at same price
No Frictions
-No transaction costs
-No tax subsidies
-No bankruptcy costs
-No agency costs
No information asymmetries

Question 5

Homemade Leverage

Answer 5

Investors borrow and lend to create their own portfolios
-must be at same interest rate as the firm
-If investor wants more leverage then borrow through margin loan and buy more shares
-If investor wants less leverage sell asset and buy risk free

Question 6

MM Prop I equation

Answer 6

A= D+ E = U

Question 7

MM Prop II

Answer 7

Cost of capital of levered equity increases with the firm’s market value debt to equity ratio
-relies on the market value of the firm being equal to the weighted average of the returns of the securities in the portfolio
-In perfect market, the overall value and risk of assets does not change with leverage

Question 8

MM Prop II equation

Answer 8

Re =Ru +D/E(Ru-Rd)

Question 9

Dilution

Answer 9

A fixed amount of earning sis divided by a greater number of shares
-Equity holders own less of the firm with equity issuances thus price per share falls
-> does not associate a gain or less to shareholders bc of fair price