BUS 295 Lecture Notes - Lecture 27: Franco Modigliani, Merton Miller, Capital Structure
Document Summary
Leverage: debt acts as a lever to magnify the gains and losses of shareholders, leverage is provided by fixed costs (both operating and financial) What are the consequences of financial leverage: magnifies return (e. g. eps) This is essentially a choice between debt and equity. In the following pages, we will develop arguments that help answer this question. The arguments are based on the nobel prize winning work of merton miller and. We will start by assuming perfect capital markets. This is like the no friction analysis in physics. It may not be realistic, but it helps us get to the final solution by enabling us to develop the ideas. Let us now introduce a small dose of realism into this perfect world. We need to add a couple more simplifying assumptions: earnings = cash flows (no depreciation, etc. , all cash flows are perpetuities, thus all debt is rolled over. In this simplistic world, the m&m proposition with taxes implies:
