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Hoorcolleges Finance II
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Hoorcollege 1We will explore companies’ choices in perfect capital markets:
● All securities are fairly priced
● There are no taxes or transaction costs
● The cash flows of the firm’s projects are not affected about how the firm finances them
The key idea is to maximize the value of the firm, regardless of decisions.
Value = present value of expected future cash flows:
A firm finances itself through financial markets by short-term debt or long-term debt. They
receive cash flows and these cash flows are paid back to the financial markets through
dividends or debt payments. Ultimately, the firm must be a cash generating activity. To survive,
the cash flows from the firm must exceed the cash flows from the financial markets.
Firms want to maximize earnings, cash flows and returns (assets) and want to minimize the cost
of capital (equity and liabilities).
Capital structure → the relative proportions of debt, equity and other securities that a firm has
outstanding
Leverage → debt to equity ratio
Debt → promised interest payment and repayment of the principal amount
Characteristics: Tax deductible, fixed maturity, no control rights, senior securities (debt holders
are the first ones in line to collect the residuals)
Equity → residual claim (when a firm goes bankrupt debt holders will be paid first and equity
holders second)
Characteristics: No tax advantage, indefinite maturity, management control, limited liability
Unlevered equity → equity in a firm with no debt
Because there is no debt, the cash flows of the unlevered equity are equal to those of the
project.
,Levered equity → equity in a firm that also has debt outstanding
The cash flows of the debt and equity sum to the cash flows of the project.
Consequently, you would be indifferent between these two choices for the firm’s capital
structure. The “Law of One Price” implies that leverage will not affect the total value of the firm.
Instead, it merely changes the allocation of cash flows between debt and equity, without altering
the total cash flows.
Leverage increases the risk of the equity of a firm. Therefore, it is inappropriate to discount the
cash flows of levered equity at the same discount rate of 15% that is used for unlevered equity.
Investors in levered equity will require a higher return to compensate for its increased risk.
The relationship between risk and return can be evaluated more formally by computing the
sensitivity of each security’s return to the systematic risk of the economy.
Leverage increases the risk of equity even when there is no risk that the firm will default. Thus,
while debt may be cheaper, its use raises the cost of capital for equity. Considering both sources
together, the firm’s average cost of capital with leverage is the same as for the unlevered firm.
Modigialni and Miller (MM) argued that with perfect capital markets, the total value of a firm
should not depend on its capital structure. They reasoned that the firm’s total cash flows should
equal the cash flows of the project, and therefore have the same present value. Set of
conditions referred to as perfect capital markets:
● Investors and firms can trade the same set of securities at competitive market prices
equal to the present value of their future cash flows.
● There are no taxes, transaction costs, or issuance costs associated with security trading
● A firm’s financing decisions do not change the cash flows generated by its investments,
nor do they reveal new information about them.
Homemade leverage → investors use leverage in their own portfolios to adjust the leverage
choice made by the firm.
,In each case, your choice of capital structure does not affect the opportunities available to
investors. Investors can alter the leverage choice of the firm to suit their personal tastes either
by borrowing and adding more leverage or by holding bonds and reducing leverage. With
perfect capital markets, different choices of capital structures offer no benefit to investors and
does not affect the value of the firm.
MM Proposition I → In a perfect capital market, the total value of a firm 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
Market Value Balance Sheet → balance sheet where all assets and liabilities of the firm are
included (also intangible assets). All values are current market values rather than historical
costs.
Leverage and the Equity Cost of Capital
E → market value of equity in a levered firm
D → market value of debt in a levered firm
U → market value of equity in an unlevered firm
A → market value of the firm’s assets
According to proposition I, the total market value of the firm’s securities is equal to the market
value of its assets, whether the firm is unlevered or levered. Dus, E + D = U = A
MM Proposition II → The cost of capital of levered equity is equal to the cost of capital of
unlevered equity plus a premium that is proportional to the market value debt-equity ratio.
(BEKIJK FINANCE I HOORCOLLEGE)
If a firm is unlevered, all of the free cash flows generated by its assets are paid out to its equity
holders. With perfect capital markets, a firm’s WACC (Weighted Average Cost of Capital) 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. The market value, risk, and cost of capital for the
firm’s assets and its equity coincide and, therefore: Ru = Ra.
,Hoorcollege 2
Corporations pay taxes on their profits
after interest payments are deducted.
Thus, interest expense reduces the
amount of corporate taxes. This
creates incentives to use debt.
Interest Tax Shield → The reduction in taxes paid due to the tax deductibility of interest.
In Macy’s case the gain is equal to the reduction in taxes with leverage: 875 - 725 = 150
, Interest gives a tax savings of 35% x 430 = 150
Interest Tax Shield = Corporate Tax Rate x Interest Payments
The benefit of leverage for the value of the firm is computed as the present value of the stream
of future interest tax shields the firm will receive. Each year a firm makes interest payments, the
cash flows it pays to investors will be higher (with leverage) than they would be without leverage
by the amount of the interest tax shield.
VL = VU + PV (interest tax shield)
You can see that the value of the firm is higher for a levered firm than an unlevered firm.
Changing capital structure does change firm value when you add imperfections (taxes in this
case).
Wanneer Debt permanent wordt gehouden, dan
zal (n) in de formule hierboven oneindig zijn. Dit
betekent dat (1+r)n zo’n groot getal wordt,
waardoor 1/(1+r)n gelijk zal zijn aan 0.
Geometric progression formula is dan gelijk aan
X/r. Dit is hetzelfde als de formule die je hier
links ziet.
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