FNCE10001 Chapter Notes - Chapter 14: Capital Structure, Capital Market, Risk Premium
25 May 2018
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Capital structure = relative proportions of debt, equity and other securities that a firm has
outstanding
Financing a firm with equity:
NPV = initial investment + expected cash flow / (risk
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free interest rate + risk premium)
Market value of firm's equity = expected cash flow / (risk
-
free interest rate + risk premium)
By selling the equity in the firm, the owner can raise market value and keep project's NPV as a profit
after paying investment cost
Unlevered equity = equity with no debt
Risk of unlevered equity = risk of project
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> shareholders earn appropriate return for risk they take
Financing a firm with debt and equity:
Project's cash flow will always be enough to repay debt
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> debt is risk free
Firm can borrow at risk
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free interest rate
Levered equity = equity in a firm that also has debt outstanding
Payments to debt holders made before payments to equity holders
With perfect capital markets, total value of a firm does not depend on capital structure
Combined values of debt and equity equals cash flows of project
Levered equity will sell for lower price but same total is raised in the end
Effect of leverage on risk and return:
Leverage increases risk so it is inappropriate to discount cash flows at same discount rate used for
unlevered equity
Leverage increases risk of equity even when there is no risk that the firm will default
Equity vs Debt Financing
Friday, 12 May 2017 9:55 PM
Principles of Finance Page 1
Investors and firms can trade same set of securities at competitive market prices equal to
present value of future cash flows
1.
No taxes, transaction costs or issuance costs associated with security trading
2.
Firm's financing decisions do not change cash flows generated by investments, nor reveal new
information about them
3.
Conditions of perfect capital markets:
MM Proposition I:
In a perfect capital market, the total value of a firm's securities is equal to the market value of the
total cash flows generated by its assets and is not affected by its choice of capital structure
MM and the Law of One Price:
Total cash flow paid out to firm's security holders = total cash flow generated by assets
By the Law of One Price, securities and assets must have same total market value
As long as choice of securities does not change cash flows generated by assets, decision does not
change total value of firm or amount of capital it can raise
Homemade leverage:
If investors prefer alternative capital structure to what firm has chosen, they can borrow or lend on
their own and achieve the same result
Homemade leverage = when investors use leverage in their own portfolios to adjust leverage choice
made by firm
Market value balance sheet:
All assets and liabilities are included
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including intangible assets (eg. Reputation, brand name,
human capital) that are excluded from accounting balance sheet
1.
All values are current market values (instead of historical costs)
2.
Similar to accounting balance sheet with two distinctions:
Market value of equity = market value of assets
-
market value of debt and other liabilities
Leveraged recapitalisation = when a firm repurchases a significant percentage of its outstanding
shares
Modigliani
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Miller: Leverage, Arbitrage and Firm Value
Saturday, 13 May 2017 8:02 PM
Principles of Finance Page 2
Document Summary
Capital structure = relative proportions of debt, equity and other securities that a firm has outstanding. Npv = initial investment + expected cash flow / (risk-free interest rate + risk premium) Market value of firm"s equity = expected cash flow / (risk-free interest rate + risk premium) By selling the equity in the firm, the owner can raise market value and keep project"s npv as a profit after paying investment cost. Risk of unlevered equity = risk of project -> shareholders earn appropriate return for risk they take. Project"s cash flow will always be enough to repay debt -> debt is risk free. Levered equity = equity in a firm that also has debt outstanding. Payments to debt holders made before payments to equity holders. With perfect capital markets, total value of a firm does not depend on capital structure. Combined values of debt and equity equals cash flows of project.
