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Summary for the course 'Corporate Finance'. This summary was written in order to study for the final. Everything you need to know is available in this summary. Note: make sure to also study the tutorials. These are as important as the materials dis...
,Chapter 14 – Capital structure in a perfect capital market
Definitions:
Capital structure: relative proportions of debt, equity, and other securities outstanding
Cost of capital / required return (Re): return required by investors who provide capital
Leverage: the use of debt in order to undertake an investment
→ The more debt, the more leverage
Leverage ratio: debt / (debt + equity)
Debt-to-equity ratio: debt/equity
Market-value balance sheet: different than a standard
balance sheet, since it represents the value of the assets
as of right now. So, the price of assets if they were sold at
this moment. This has to be equal to investors paying for
an investment on the right-hand side of the balance sheet.
Also, it represents intangible assets such as brand and
reputation.
Unlevered firm: firm that only uses equity and no debt
→ How much is equity worth in such a firm?
→ Unlevered equity = PV of expected cash flows
Modigliani-Miller I:
Perfect capital markets:
- Investors/firms can trade same set of securities at competitive prices equal to the PV of
their future cash flows.
- No taxes and other additional costs
- Future investment’s cash flows are independent of a firm’s capital structure.
Example:
If you have a pizza which you will slice in 8 pieces, the pizza remains the same value. The pizza is
the value of a company. Hence, when splitting up a company, the value of the company remains
the same. If you were to buy a pizza you wouldn’t ask in how many slices the vendor is going to
slice the pizza.
3
, Unlevered firm vs. levered firm:
Firm 1 - unlevered:
- Only uses equity (=unlevered)
- Unlevered equity = PV of expected cash flows = PV(0.5*1400 + 0.5*900)
- Cost of capital (Re) consists of discount interest rate and risk premium
Price of equity = PV(Cash flows) = ?
= (½ * 1400 + ½ * 900) / 1 + Re
→ Re = Rf + β*MRP (risk-free rate + β*market risk premium)
→ Market risk premium = E[return on market (Re) – risk free rate (Rf)]
→ β = correlation of investment with market
→ Rf = 0.05, β = 1, MRP = 0.10
= (½ * 1400 + ½ * 900) / 1.15
= .15
Price of equity = 1000
Firm 2 – levered:
- Uses both equity & debt (=levered)
- Debt value = $525
- Debt market value = 525/1.05 = $500 (you can use the risk-free rate of 5% as the
cashflow is always higher than the debt. Therefore, debt is a risk-free security)
Price of equity = PV(cash flows) = 500 (since 1000-500, because of the debt market value. The
balance sheet needs to be in balance, so on both sides 1000.)
→ (½*(1400-525) + ½*(900-525)) / 1 + Re = 500 (you subtract the debt, because it will be
subtracted from future cash flows when the debt is paid).
Price of equity = 500 (with the same variable values)
Cost of equity = 25% (it increased from 15% to 25%!).
→ Equity has become riskier because the firm has debt now, and therefore equity is more
expensive.
→ β has also increased from 1 to 2
→ Re = Rf + β * MRP
→ 25% = 5% + β*10%
→β=2
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