33:390:400 Lecture Notes - Lecture 3: Capital Structure, Cash Flow, Tax Shield

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Chapter 16: Capital Structure
Review of Equations:
ROE = (ROA) x (Equity Multiplier)
- Equity Multiplier = (Total Assets) / (Equity)
16.1: The Capital Structure Question and the Pie Theory
Total value of a firm: V = D + E
- D: Market value of the firm’s debt
- E: Market value of the firm’s equity
- V: The sum of the firm’s debt and equity or Market Value of firm’s assets
The Pie Model = Total capital structure of a firm; measures the % of Debt and Equity
- Capital structure decision: What is the best way to slice up the pie
- Goal: Make the firm as valuable as possible
- Do this by creating the best D/E ratio to yield the most value
Can we choose the ratio of D to E in a way that maximizes V?
16.2: Maximizing Firm Value versus Maximizing Stockholder Interests
Highest firm value will lead to highest capital structure will maximize shareholder wealth
Do shareholders want managers to maximize V or E?
- MAXIMING FIRM VALUE = MAXIMIZING EQUITY VALUE
- Change in value of the firm is the same as the net effect on the stockholders
- Maximizing V = Maximizing shareholder profit
- Firm Value should stay the same
16.3: Financial Leverage and Firm Value: An Example
EPS (y) by EBIT (x) graph: Two lines, one w/debt and one no debt, shows where debt is optimal
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- Slope of the line with debt is higher than the slope of the line without debt
- The effect of financial leverage depends on the firm’s EBIT.
- When EBIT is relatively high, leverage is beneficial
- Leverage makes good times great, but makes bad times even worse
- Shareholders are not necessarily better off with the levered capital structure
- Depends on the risk-return tradeoff
- Investors can replicate the patterns of payoffs, whether a firm has financial leverage or not
- This is known as Homemade Leverage
- Borrowing money from your personal account to buy more shares
Modigliani and Miller (MM) Proposition I: You cannot change the value of a firm
- Changing capital structures will not change the total value of a firm
MM Proposition I (no taxes):
- The value of a levered firm = the value of an unlevered firm
VL = VU
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Document Summary

Capital structure decision: what is the best way to slice up the pie. Goal: make the firm as valuable as possible. Do this by creating the best d/e ratio to yield the most value. Equity multiplier = (total assets) / (equity) D: market value of the firm"s debt. E: market value of the firm"s equity. V: the sum of the firm"s debt and equity or. 16. 1: the capital structure question and the pie theory. Total value of a firm: v = d + e. The pie model = total capital structure of a firm; measures the % of debt and equity. 16. 2: maximizing firm value versus maximizing stockholder interests. Highest firm value will lead to highest capital structure will maximize shareholder wealth. 16. 3: financial leverage and firm value: an example. Eps (y) by ebit (x) graph: two lines, one w/debt and one no debt, shows where debt is optimal. Maximing firm value = maximizing equity value.

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