Week 1: Overview of Capital Structure Flashcards
What are the 4 assumptions of the Modigliani-Miller model?
1) Homogenous expectations.
2) Homogenous business risk classes.
3) Perpetual cash flows.
4) Perfect capital markets.
What are the 5 characteristics of perfect capital markets?
1) Perfect competition.
2) Firms & investors can borrow/lend at same rate.
3) Equal access to all relevant info –> no info asymmetry.
4) No transaction costs.
5) No taxes.
What is Proposition 1 of the Modigliani-Miller theorem?
Total mkt value of firm (=DEBT+EQUITY) independent of how it is financed (its capital structure), assuming:
1) Sum of all future CFs to future debt & equity holders unaffected by capital structure –> i.e. investors can adjust their portfolios such that there are no value implications between diff levels of debt/equity in capital structure (investors can ‘undo’ a firm’s capital structure choice) –> i.e. firm’s share price & value of existing senior debt claims unaffected by changes in firm’s capital structure.
.2) No transaction costs.
3) No arbitrage –> any changes in firm’s capital structure offset by corresponding changes in values of its securities, resulting in an unchanged total firm value i.e. two investments w identical cash flows in all future states of world must have same mkt value today so value of levered & unlevered companies must be equal, if arbitrage opportunity presented & eventually eliminated.
What is the (value, V) of a firm?
(Value, V) = (S, equity) + (B, debt)
How would firm management make firm as valuable as possible?
Pick optimal debt-to-equity ratio maximising total value, V.
What is evidence that capital structure and distribution policy matter?
1) Corporations spend resources i.e. debt/equity financing on their design/projects.
2) Stock prices react dramatically to financing decisions –> prices increase to announcements by firms that: 1) they will redistribute cash to shareholders (share repurchase) ; 2) they will increased their leverage (could have disciplinary impact on management to maintain high performance to maintain interest & principal payments OR could create more value because interest payments are tax-deductible) –> prices decrease to announcements by firms that: 1) they will raise cash (may signal insufficient earnings) ; 2) they will decrease their leverage.
What are the 2 benefits of using debt financing?
1) Corporate tax shields.
2) Personal tax shields.
Why does the existence of only corporate tax favour debt financing for firm’s value?
–> Assume pre-tax CFs subject to standard MM assumptions –> debt financing reduces tax if debt constant, risk free & perpetual –> increase in leverage reduces share of total firm value taken by gov. as tax & hence increases sum of mkt values of debt & equity as interest payments are tax-deductible –> hence V_L =V_U+PV(Tax Shields) –> value of firm increases w leverage by amount TcD (tax gain to leverage) –> w corporate taxes but no personal taxes, a firm’s optimal capital structure will include enough debt to completely eliminate firm’s tax liabilities.
How does the existence of corporate tax AND personal tax (on debt & equity) affect firm value?
–> Assume pre-tax CFs subject to standard MM assumptions –> suppose tax rate on debt T_D & tax rate on equity T_E is same –> if debt fixed, risk free & perpetual then V_L=V_U+gD where gD=PV of tax gain (g=growth rate of tax shield)–> when g>0 leverage reduces taxes & increases value ; when g<0 leverage increases taxes & reduces value ; when g=0 leverage does not affect value.
Why is it that under the presence of taxes investors cannot ‘undo’ capital structure decisions?
E.g. debt typically provides tax shield because interest payments are tax-deductible expenses for firm, reducing its taxable income & tax liability but equity financing does not offer such tax advantages.
