Topic11Slides.pptVIP

* Economics of Finance and Investment Optimal K Structure Dr Giuseppina Madonia * Topics Covered Leverage in a Tax Free Environment How Leverage Affects Returns * What You Will Learn - Understand MM’s Propositions I and II - Understand the ass’s underlying these propositions - Understand the effect of leverage on the firm’s value, cost of debt, cost of equity, and the overall cost of k under MM’s propositions. * Objective of the Firm: To maximise its overall mkt value. Main Q: Is the value of the firm unaffected by its choice of k structure? Main A: Modigliani and Miller (MM) showed that in perfect k mkts, k structure is irrelevant. * Introduction So far we have assumed that firms are all equity financed. But in practise a firm can raise funds also by issuing corporate bonds or by bank borrowing. K structure is the firm’s mix of different types of securities. An important Q is thus: What is the optimal debt/equity ratio? * MM showed that the financing decision doesnt matter in perfect capital markets. MM Proposition I states that the total value of a firm is the same irrespective of its debt/equity ratio (assuming perfect k mkts, eg no taxes etc). This proposition allows the complete separation of investment and financing decisions. MM Proposition II states that the return on equity is a linear function of the debt/equity ratio (leverage). * However, in practise k structure does matter. Why then study MM’s theory? Understanding MM’s theory facilitates understanding of why one K structure is better than another; (ii) MM’s theory highlights imperfections (eg taxes, costs of bankruptcy, costs of debt contracts etc) * To understand MM’s Proposition I we need: To understand the idea of financial leverage, To recall the additivity property of PV and, Understand that as an investor, you are only concerned with the E (R) on your investment. * There are only 2 Financial Instruments, Bonds and Equities, then the value of a firm i