DoesDebtPolicyMatter.pptVIP

Does Debt Policy Matter? Student Presentations Capital Structure Considerations Modigliani and Miller – Propositions 1 and 2 Financial Risk and Expected Returns Weighted Average Cost of Capital (WACC) After Tax WACC Capital Structure Capital structure is mixture of debt and equity Firm value is total value of debt plus equity Types of equity Common Preferred Types of debt Term Seniority Covenants Hybrids Convertible bonds Modigliani and Miller – Proposition 1 Capital structure does not matter if: Total cash flows do not change based on capital structure Markets are perfect No frictions (taxes or bankruptcy costs) Corporations have no borrowing advantage Investors have access to any desired investment This means that if the capital markets are providing adequate investment choices, then a firm’s value is independent of the debt ratio Illustration of MM Prop. 1 Two firms with exactly the same operating income Investor owns 1% of each firm’s securities Firm U is unlevered (all equity) Firm L is levered (has issued debt) Therefore, the value of the two firms must be equal Another Illustration Investor owns 1% of levered firm L Investor owns 1% of unlevered firm U and borrows an amount equal to 1% of the debt of the levered firm Therefore, the value of the two firms must be equal Modigliani and Millers Proposition I states that: A) The market value of any firm is independent of its capital structure B) The market value of a firms debt is independent of its capital structure C) The market value of a firms common stock is independent of its capital structure D) All of the above E) None of the above Law of Conservation of Value Two streams of cash flow Stream A has a present value of PV(A) Stream B has a present value of PV(B) Value additivity The present value of the combined cash flows A+B is PV(A) + PV(B) Conservation of value Splitting up a cash flow into different parts does not affect the total value of the parts Example Macbeth Spot Removers