FIN 401 Lecture Notes - Lecture 4: Cash Flow, Capital Structure, Risk Premium

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Example #1 financing a new business in a pcm. You have the opportunity to run a coffee shop in the lobby of a nearby office building for one year. Your research indicates that an upfront investment of ,000 is required to start. After covering your operating costs (including your wage), you expect to generate a cash flow of ,500 at the end of the year. Returns to equity with and without debt . The effect of leverage on the cost of capital: for any choice of capital structure, the firm"s pre-tax wacc is unchanged and remains equal to the firm"s unlevered cost of capital. The effect of leverage m&m proposition ii. 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 debt-to-equity ratio (measured using market values) r. We want to choose the capital structure that will maximize stockholder wealth.

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