week 9 Flashcards
what is capital structure
the mix of debt and equity that it uses to finance its activities.
what is the optimal capital structure
¡The capital structure which maximises the value of
a company.
why do firms borrow if it involves extra risk?
by borrowing, a company may be able to increase the rate of return earned by its shareholders.
this effect is known as financial leverage which is measured by debt-equity ratio or debt-total assets ratio
If the rate of return on a company’s assets is greater than the interest rate on its debt
borrowing will increase the rate of return to shareholders.
vice versa
Financing a Firm with Equity
nUnlevered Equity
what does this mean
¡Equity in a firm with no debt
nBecause there is no debt, the cash flows of the unlevered equity are equal to those of the project.
what happens when the project’s cash flow will always be enough to repay the debt
the debt is risk free and you can borrow at the risk-free interest rate of 5%
Modigliani and Miller argued that
with perfect capital markets, the total value of a firm should not depend on its capital structure; the company is independent of its capital structure
describe the law of one price
the cash flows of the debt and equity equal to the sum to the cash flows of the project
Leverage increases the
therefore?
nthe risk of the equity of a firm.
investors in levered equity will require a higher expected return to compensate for the increased risk.
when The project cash flows depend on the overall economy
what exists? what will you do?
market risk
As a result, you demand a 10% risk premium over the current risk-free interest rate of 5% to invest in this project.
Leverage increases the risk of equity even when
there is no risk that the firm will default.
while debt may be cheaper, its use
_______
Considering both sources of capital together _________
raises the cost of capital for equity
. Considering both sources of capital together, the firm’s average cost of capital with leverage is the same as for the unlevered firm.
Modigliani & Miller Analysis
is based on what assumptions?
- Securities issued by companies are traded in a perfect capital market; this is a frictionless market in which there are no transaction costs and no barriers to the free flow of information.
- There are no taxes.
- Companies and individuals can borrow at the same interest rate.
- There are no costs associated with the liquidation or reorganisation of a company in financial difficulty.
- Companies have a fixed investment policy so that investment decisions are not affected by financing decisions.
MM’s Proposition 1
The market value of any firm is independent of its capital structure
if a company has a given investment policy, then changing its ratio of debt to equity will change the way in which its net operating cash flows generated by assets are divided between lenders and shareholders, but will not change the total value of the cash flows.
- Regardless of how they are divided, their total size remains the same. Therefore, the value of the company’s assets remains the same.
- that the firm’s total cash flows still equal the cash flows of the project, and therefore have the same present value.
- Therefore, the value of the company will not change.
Proposition 1: Proof
nTwo companies that have the same assets but different capital structures are, under the assumptions, perfect substitutes. As such, perfect substitutes should have the same value.
Proposition 1: Proof
what can investors create?
The proof provided by MM is based on the idea that investors can create homemade leverage
- ¡When investors use leverage in their own portfolios to adjust the leverage choice made by the firm.
¡MM demonstrated that if investors would prefer an alternative capital structure to the one the firm has chosen, investors can borrow or lend on their own and achieve the same result.
What if …nThe companies were not selling for the same price?
nArbitrage profits could be earned. An opportunity to make riskless profits exists and arbitragers will exploit this.
arbitrage
¡Arbitrage involves buying an asset and simultaneously selling it for a higher price, usually in another market, so as to make a
risk-free profit.
if the value of the levered company exceeds the value of the unlevered company,
an investor in the levered company should sell her shares and instead borrow money and invest in the shares of the unlevered company
if the value of the levered company exceeds the value of the unlevered company,
what will eventually happen?
If enough investors undertake similar transactions, there will be downward pressure on the price of L shares (because there are many sellers) and upward pressure on the price of U shares (because there are many buyers). Equilibrium will be restored when security prices have adjusted to the point where the market values of the two companies are equal.
If a levered company is overvalued, an investor in that company’s shares can
- replicate his risk and return by investing instead in the shares of an unlevered company and adjusting the debt–equity ratio by borrowing personally.
- Hence, leverage does not add value to a levered company because, by borrowing, the levered company is not doing anything that its shareholders cannot do for themselves.
if an unlevered company is overvalued, an investor in that company’s shares can
replicate his risk and return by investing instead in the shares of a levered company and adjusting his debt–equity ratio (to zero) by lending personally.
Leverage neither adds to, nor subtracts from, the value of a company.
what does arbitrage ensure
ensure that perfect substitutes will not sell at different prices in the same market at the same time.
describe substitutes in the context of MM’s analysis
In the context of the MM analysis, two companies with the same assets, but different capital structures, are perfect substitutes.








