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Summary MFA Finance
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this document provides with all the main concepts of MFA regarding the Finance part, all with graphs, formulas and definitions.
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MANAGERIAL FINANCE AND ACCOUNTINGFINANCE
CHAPTER 14 “Capital Structure in a Perfect Market” → When a firm needs to raise new
funds to undertake its investments, it must decide which type of security it will sell to investors.
This is explored in a perfect capital market, in which all securities are fairly priced, there are no
taxes or transaction costs, and the total cash flows of the firm’s projects are not affected by how
the firm finances them. In this situation, the Law of One Price implies that the choice of
debt/equity financing will not affect the total value of the firm, its share price or cost of capital.
The Capital Structure of a firm is constituted by the relative proportions of debt, equity and other
securities that a firm has outstanding.
To raise capital, companies have two types of securities as an option:
- Equity Financing
Given an initial investment, the cash flows depend on the overall economy, so it contains
market risk. As a result, investors demand a risk premium. In absence of arbitrage, the
price of a security equals the present value of its cash flows. Equity holders will receive
the cash flows generated on date 1.
- Debt Financing
Unlevered Equity: equity in a firm with no debt. The firm is unlevered when equity is used
without debt.
Levered Equity: equity in a firm that also has debt outstanding. The amount of debt determines
the firm’s leverage.
Modigliani and Miller argued that with perfect capital markets, the total value of a firm should not
depend on its capital structure. The firm’s total cash flows still equal the cash flows of the
project, so have the same present value.
The owner of a firm should choose the capital structure that maximizes the total value of the
securities issued.
Leverage does not affect the total value of the firm, it changes the allocation of cash flows
between debt and equity. MM showed that this result holds under a set of conditions → Perfect
Capital Markets.
1. Investors and firms can trade the same set of securities at competitive market prices
equal to the present value of their future cash flows.
2. There are no taxes, transaction costs, or issuance costs associated with security trading.
3. Financing decisions do not change the cash flows generated by its investments, nor do
they reveal new info about them.
, MM demonstrated the following result regarding the role of capital structure
MM Proposition I: In a perfect capital market, the total value of a firm’s securities is equal
to the market value of the total cash flows generated by its assets and is not affected by its
choice of capital structure.
By the Law of One Price, the firm’s securities and its assets must have the same total
market value. If the firm’s choice of securities does not change the cash flows generated by its
assets, this won’t change the total value of the firm or the capital it can raise.
Investors can borrow/lend their own and achieve the same result. When they use
leverage in their own portfolios, they are using homemade leverage. A perfect substitute for the
use of leverage by the firm.
Market value balance sheet captures the idea that value is created by a firm’s choice of asset
and investments. It includes:
- all assets and liabilities are included, even intangible assets.
- all values are current market values rather than historical.
MM Proposition II: The cost of capital of levered equity increases with the firm’s market
value debt-equity ratio.
With perfect capital markets, a firm’s WACC is independent of its capital structure and is equal
to its equity cost of capital if it is unlevered, which matches the cost of capital of its assets.
Debt is less risky than equity, it has a lower cost of capital. This benefit is offset by the higher
equity cost of capital, leaving a firm’s WACC unchanged with perfect capital markets.
WACC is constant while cost of equity increases with leverage
The market risk of a firm’s assets can be estimated by its unlevered beta.
When a firm changes its capital structure without changing investments:
- its unlevered beta will remain unaltered.
- its equity beta will change to reflect the effect of the capital structure change on its risk
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