25300 Lecture Notes - Lecture 10: Financial Risk, Capital Structure, Capital Market
Components of value in a perfect capital market with company tax
M&M proposal = cost of capital remains constant regardless of debt level
Value of firm is independent of its capital structure (relies on real assets)
States that how a firm chooses to arrange its finances is irrelevant
VL = Vu (Value levered = Value unlevered) WACC is the same either way
*Doesn’t consider tax
*Re = cost of equity
* Business risk: not affected by capital
structure (depends on operations & assets – systematic risk = Ra)
*Financial risk: degree of financial
leverage (D/E)
*As firm increases its debt to equity ratio,
increase in leverage raised the risk of
equity and required return on it
* Ra = WACC = constant
Proposition 1: firms overall cost of
capital is unaffected by its capital
structure
E/V and D/V is offset by change in Re
So WACC stays the same.
• Explain homemade leverage
*Shareholders can adjust the amount of financial leverage by undertaking
personal borrowing (investors themselves borrow)
* Able to improve EPS and ROE as if the company used leverage
(Provided it is a perfect Market – no taxes etc)
• Articulate effects of financial distress on capital structure
*Problems company experience when they borrow too much money
*Failure to meet debt obligations can result in bankruptcy (added cost)
Document Summary
Components of value in a perfect capital market with company tax. M&m proposal = cost of capital remains constant regardless of debt level. Value of firm is independent of its capital structure (relies on real assets) States that how a firm chooses to arrange its finances is irrelevant. Vl = vu (value levered = value unlevered) wacc is the same either way. *doesn"t consider tax structure (depends on operations & assets systematic risk = ra) *as firm increases its debt to equity ratio, increase in leverage raised the risk of equity and required return on it. Proposition 1: firms overall cost of capital is unaffected by its capital structure. E/v and d/v is offset by change in re. So wacc stays the same: explain homemade leverage. *shareholders can adjust the amount of financial leverage by undertaking personal borrowing (investors themselves borrow)
