Crede

In: Business and Management

Submitted By Robehgene
Words 2554
Pages 11
Financial Management
Capital Structure

1

Capital Structure
This lecture will explore the determinants of the mix of debt and equity the firm uses to finance its operations. • We will first explore the situations under which capital structure is irrelevant to a firms operations. Examining these situations will allow us to explore how the following factors influence the mix of debt and equity a firm uses to finance its operations. • TAXES • RISK • FINANCIAL SLACK • ASSET CHARACTERISTICS • COSTS OF FINANCIAL DISTRESS.

Capital Structure - 1

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The Capital Structure Question
MODIGLIANI – MILLER (MM): IRRELEVANCE OF CAPITAL STRUCTURE A. Firm Value and Capital Structure: • Modigliani-Miller (MM) Proposition I: The value of the firm is independent of the capital structure of the firm UNDER certain assumptions.
– 1st Arbitrage Proof in Finance: – Concept of Homemade Leverage.
Capital Structure - 2 3

Assumptions of MM:
COMPLETE AND PERFECT CAPITAL MARKETS Capital Structure Does Not Matter IF: • No Taxes - Assumption Relaxed. • No Bankruptcy Costs • No Costs of Enforcing Debt Contracts or issuing securities. • Investment Opportunities are Given • Homogeneous Expectations about the Investment Opportunities of Firms

Capital Structure - 3

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MM Proposition II:
The cost of equity capital for a levered firm = • The constant overall cost of capital + a risk premium. re = ra + (1 − tc )(ra − rd ) D E

•Where the risk premium due to debt = the spread between the overall cost of capital and the cost of debt multiplied by the firm's debt equity ratio. and: re = required rate of return for equity. rd = required rate of return for debt. ra (or ρ) = required rate of return of a company with 100% equity (the same as the asset required rate of return). & tC is the corporate tax rate.
Capital Structure - 4 5

The CAPM and MM Proposition II
• Both…...

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