Advanced Corporate Finance: Capital Structure 1, 2 & 3
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Vak
BMAN30111 Advanced Corporate Finance (BMAN30111)
Instelling
The University Of Manchester (UOM)
Boek
Corporate Finance, Global Edition
This note includes capital structure1, 2 and 3, which covers Modigliani and Miller’s (1958) Proposition1&2, agency costs of equity and agency costs of debt.
Key points and important formula are highlighted with colour.
Test Bank for Corporate Finance, 5th Edition by Jonathan Berk, DeMarzo Chapter 1-31 A++
UPDATED Finance 1 for Business Summary
Test Bank For Corporate Finance The Core, 5th Edition by Jonathan Berk, Peter DeMarzo Chapter 1-19
Alles voor dit studieboek
(102)
Geschreven voor
The University of Manchester (UOM)
Onbekend
BMAN30111 Advanced Corporate Finance (BMAN30111)
Alle documenten voor dit vak (4)
Verkoper
Volgen
phyllisho
Voorbeeld van de inhoud
Capital Structure
Capital Structure 1.................................................................................................................. 1
Modigliani and Miller’s (1958) Proposition..........................................................................1
Capital Structure with Corporate Taxes.............................................................................3
Capital Structure with both Corporate and Personal Taxes................................................5
Empirical Evidence on Taxes and Capital Structure..........................................................7
The Low-leverage Puzzle...................................................................................................8
Capital Structure 2:.................................................................................................................9
Bankruptcy Costs and Financial Distress...........................................................................9
The Trade-off Theory of Optimal Capital Structure............................................................9
Asymmetric Information Models.......................................................................................10
Predictions of POT........................................................................................................... 13
Agency Costs of Equity and Corporate Governance............................................................15
1. Corporate Governance definition.................................................................................15
2. Principal-Agent Model..................................................................................................15
3. Agency Problems.........................................................................................................15
4. Solutions to Agency Costs of Equity............................................................................18
Capital Structure 3: Agency cost of debt...............................................................................24
Agency cost of debt......................................................................................................... 24
Source of debtholder-shareholder conflicts......................................................................24
Control Mechanisms........................................................................................................ 26
Theories of capital structure with agency costs................................................................27
Capital Structure 1
Modigliani and Miller’s (1958) Proposition
1. M&M Irrelevance proposition 1:
● Total value of firm is not affected by capital structure under perfect market
condition : Firm value = total cash flow generated by assets
, ● Assumptions of the MM1
○ Perfect capital market without frictions
- No taxes, transaction and insurance costs
- No agency problems and asymmetric information
○ Investors and firm can borrow and lend at the same rate
○ Financing decisions do not change the cash flows generated by
investments
○ No Arbitrage
● Proof of the proposition
○ Arbitrage opportunity are available if MM1 does NOT hold
○ Find 2 identical firms except for capital structures (V l∧V U ¿
○ Arbitrage exists if both firms do not have the same value
○ Example: Homemade leverage, V U > V l
- V U = £100m; V l = £90m where D = £30m and El = £60m
- An investor buy 10% of El (£6m) and 10% of D (£3m)
- And then short(sell) 10% of V U
- Earning a profit of £1 m
○ Arbitrage Profit
- At the t =1, investors receive 10% from levered firms’ share
and bonds: 0.1[X - (1+rD)*D] + 0.1(1+rD)*D
- However, the investors will have to pay out 10% of unlevered
firm ( 0.1X) to cover short sale: 0.1[X - (1+rD)*D] + 0.1(1+rD)*D
- 0.1X = 0
- Earning a profit of £1 m
- Existence of Arbitrage opportunity violates the assumption of
MM1
2. MM’s Irrelevance Proposition 2:
● The cost of equity of a levered firm (r e ¿increases as the D/E increases
(Amount of debt ⇑, cost of equity ⇑, BUT WACCremain unchanged)
● Intuition: debt may be cheaper BUT it increases the financial risk and the
cost of equity
● Derivation of Proposition 2
- Consider levered firm L = a portfolio = debit + equity
- Return on L = WACC (per tax)
E D
r WACC = r e ( ¿+r d ( )
V V
- The overall expected return on L is :
Net operating income(NOI )
r WACC =
V
- Based on MM’s assumption, NOI and V does NOT affected by capital
structure choice, so V l =V U
, - Therefore: r WACC = r U
- Next:
E D
r U = r WACC = r e ( ¿+r d (1−T c )( )
V V
- Equation of MM proposition 2:
D
r e =r U +( )(r −r )
E U d
● Implications of MM2
- Increase the amount of debt does NOT reduce WACC
- Any attempt to decrease the WACC by issuing more debts will offset
by the increase in cost of equity (WACC unchanged)
● Minimising the cost of capital
- r E rises moderately as more debt is used
- WACC ↓ first then ↑
Capital Structure with Corporate Taxes
● The total amount paid to investors is higher with leverage
● Tax advantage of debt financing: tax shield of interest payment
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