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FINM2415 Corporate Finance
Lecture 3: Capital Structure I:
Capital Structure in a Perfect Market
CRICOS code 00025B
What we study in this lecture
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Capital structure I: Capital structure in a perfect capital market: Modigliani and Miller (MM) Theory of
Capital Structure in a Perfect Capital Market
• MM Proposition I: Leverage and firm value
• MM Proposition II: Leverage and cost of capital
What we study in this lecture
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• Capital structure: the collection of securities a firm issues to raise capital from investors
• Equity and debt are the securities most commonly used by firms. Therefore, capital structure can be referred to as
the proportion of debt and equity financing that a firm has outstanding.
• Unlevered firm versus levered firm:
- Unlevered firm: a firm has only equity (E) in its capital structure. Its equity is called unlevered equity.
- Levered firm: a firm has both debt (D) and equity (E) in its capital structure. Its equity is called levered equity.
• Leverage: the extent to which a firm relies on debt financing: the more debt a firm has in its capital
structure, the higher levered the firm.
- Leverage also means capital structure and they are used interchangeably.
- Leverage can be called debt ratio. It can be calculated as debt to equity ratio (D/E) or debt to firm value
(valuation) ratio (D/V)
Capital structure concepts
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• Capital structure and the pie: the value of a firm is defined as the sum of the value of the firm’s debt
and the firm’s equity: V = D + E
If the goal of the firm’s management is to make the firm as valuable as possible,
then the firm should pick the (optimal) debt to equity ratio that makes the pie as big as possible.
• Big capital structure question: Is there an optimal capital structure (e.g., optimal debt to equity ratio)
that can maximize firm value?
• Over the next three lectures we will study this big question and its implications in different states of
capital markets (capital market imperfections). Capital structure I (today’s topic) is the capital structure
in a perfect capital market (no imperfections).
Capital structure question
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Capital structure in a perfect capital market
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• Two professors Franco Modigliani and Merton Miller developed the
theory of capital structure (Modigliani-Miller or MM theory) in 1950s
and 1960s.
The theory provides an important benchmark for capital structure/corporate finance research
• The MM theory is first based on a perfect capital market:
- No taxes, no transaction costs, or no issuance costs associated with security trading.
- A firm’s financing decisions do not change the cash flows generated by its investments or its
assets, nor do they reveal new information about them.
- Investors and firms can trade the same set of securities at competitive market prices equal to the
present value of their future cash flows.
• The MM theory has two main propositions:
- Proposition I (MMI): Leverage and firm value
- Proposition II (MMII): Leverage and cost of capital
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• In a perfect capital market, the value of a firm does not depend on its capital structure or capital
structure is irrelevant
Firm value is determined solely by the cash flows generated by its assets (investments). Whether these
assets (investments) are financed by equity or debt is irrelevant
where
Value of a firm (V)
Value of the firm’s assets (A)
Value of equity in an unlevered firm (U)
Value of equity in a levered firm (E)
Value of debt in a levered firm (D)
MM Proposition I (MMI): Leverage and firm value
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V = A = U = E + D
Leverage (D/E)
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• Why do we have MM Proposition I?
• Because the Law of One Price holds under a
perfect capital market:
Firm value is determined by total cash flows generated by
its assets (investments).
Under the law of one price, the total cash flows generated
by the firm assets equal the total cash flows paid out to all
of the firm’s security holders. Therefore, the market value
of firm’s assets must equal the market value of its
securities.
As long as the firm’s capital structure (e.g., choice of debt
and equity) does not change the cash flows generated by
its assets, the value of a firm is not affected by its capital
structure.
MMI: Leverage and firm value
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A firm has only one investment project requiring an initial investment of $800 this year, the project will
generate cash flows of either $1400 or $900 next year, depending on whether the economy is strong or
weak, respectively. Both scenarios are equally likely. The project cost of capital is 15%.
a. What is the NPV of this project? What is the total value of this project? What is the total asset value of the firm after
this investment? What is the firm value after this investment?
b. To finance this project, the project is sold to investors as an all-equity firm (the project is financed using all equity).
The equity holders will receive cash flows of the project after one year. What are the cash flows of unlevered equity
in year 1? How much the money can be raised in this way – that is, what is the market value of unlevered equity?
What is the total value of the firm?
c. Suppose that the project is financed using both debt and equity, where the firm can borrow $500 at the risk-free rate
of 5%, what are the cash flows of levered equity in year 1? What is the value of the firm according to the MM? What
is the initial value of the firm’s levered equity?
d. What do we learn from this example?
Example
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A firm has only one investment project requiring an initial investment of $800 this year, the project will
generate cash flows of either $1400 or $900 next year, depending on whether the economy is strong or
weak, respectively. Both scenarios are equally likely. The project cost of capital is 15%.
a. What is the NPV of this project? What is the total value of this project? What is the total asset value of the firm after
this investment? What is the firm value after this investment?
b. To finance this project, the project is sold to investors as an all-equity firm (the project is financed using all equity).
The equity holders will receive all cash flows of the project after one year. What are the cash flows of unlevered
equity in year 1? How much the money can be raised in this way – that is, what is the market value of unlevered
equity? What is the total value of the firm?
Example
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$200 $1,000 =$800 +$200$1,000
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· -S: 1,400= E(CF1) =0.5 x 1,400
+0.5x900 =1,1500 0.5
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IA:
NPV = -500 + =$ 208 #.
CRICOS code 00025B
A firm has only one investment project requiring an initial investment of $800 this year, the project will
generate cash flows of either $1400 or $900 next year, depending on whether the economy is strong or
weak, respectively. Both scenarios are equally likely. The project cost of capital is 15%.
b. To finance this project, the project is sold to investors as an all-equity firm (the project is financed using all equity).
The equity holders will receive all cash flows of the project after one year. What are the cash flows of unlevered equity in
year 1? How much the money can be raised in this way – that is, what is the market value of unlevered equity? What is
the total value of the firm?
Unlevered firm:
Example
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t=0 t=1
Cash flows
Assets Liabilities and Shareholders Equity Strong Weak
Investment ………………… Debt ………………… ……………… ………………
NPV (∆Asset) ………………… Unlevered equity ………………… ……………… ………………
Total ………………… Total ………………… ……………… ………………
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1,000 1,00 1,400 9,00⑧- - -
CRICOS code 00025B
A firm has only one investment project requiring an initial investment of $800 this year, the project will
generate cash flows of either $1400 or $900 next year, depending on whether the economy is strong or
weak, respectively. Both scenarios are equally likely. The project cost of capital is 15%.
c. Suppose that the project is financed using both debt and equity, where the firm can borrow $500 at the risk-free rate of 5%,
what are the cash flows of levered equity in year 1? What is the value of the firm according to the MM? What is the initial value
of the firm’s levered equity?
Levered firm:
d. What do we learn from this example?
Example
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t=0 t=1
Cash flows
Assets Liabilities and Shareholders Equity Strong Weak
Investment ……………… Debt ……………… ……………… ………………
NPV(∆Asset) ……………… Levered equity ……………… ……………… ………………
Total ……………… Total ……………… ……………… ………………
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525⑧500 500 9525 ? <- --
200 500 ? 875 ? 375
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V =Vx =V =V2 =$1,0 0
CRICOS code 00025B
• MMI shows that firm value is not affected by its capital structure. Suppose that investors
would prefer an alternative capital structure to the one the firm has chosen, what can they
do? They can do so using “Homemade Leverage”
• Homemade leverage: investors can borrow or lend on their own in order to achieve a
preferred choice of capital structure (leverage).
o If an investor would like more leverage than then firm has chosen, the investor can ……….. and add
more leverage
o If an investor would like less leverage than then firm has chosen, the investor can ………. and reduce
leverage
• As long as investors can borrow or lend at the same rate as the firm (under perfect capital
markets), homemade leverage is a perfect substitute the use of leverage by the firm, and
homemade leverage does not affect the value of the firm.
Homemade leverage
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CRICOS code 00025B
Example: There are two identical firms except for their capital structure. In these firms, all investors will receive a cash flow of either
$1,400 or $900 next year, depending on whether the economy is strong or weak, respectively. Both scenarios are equally likely. The cash
flows and the capital structure of these two firms are given in the below tables. The risk free rate is 5%.
Suppose that the current market value of unlevered equity is $990 while the current market value of
levered equity is $510. Does MMI hold? What arbitrage opportunity is available using homemade
leverage?
Homemade leverage and arbitrage opportunity
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t=0 t=1
Unlevered firm Cash flows
Liabilities and Shareholders Equity Strong Weak
Debt 0 0 0
Unlevered equity 1000 1400 900
Total 1000 1400 900
t=0 t=1
Levered firm Cash flows
Liabilities and Shareholders Equity Strong Weak
Debt 500 525 525
Levered equity 500 875 375
Total 1000 1400 900
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• MMII: Leverage and the Cost of Equity
- MMI maintains that leverage does not change the value of a firm, however, leverage increases the risk
of equity because promised payments to debtholders must be made …………. any payments to equity
holders.
- Therefore, MMII states that
o Leverage …………… the cost of equity: The cost of equity in a levered firm equals the cost of equity in an
unlevered firm plus a risk premium that is proportional to the leverage (e.g., debt-equity ratio).
MM Proposition II (MMII): Leverage and cost of capital
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• Why MM Proposition II: Why leverage increases the cost of equity?
• Because the value of levered firm equals the value of unlevered firm => holding a portfolio of the levered
firm’s equity and debt is similar to holding the equity of the unlevered firm => then the return of the levered
firm is equal to the return of unlevered firm.
o The return on an unlevered firm (RU)
o The return on a levered firm is the weighted average of the cost of its debt (Rd) and equity (Re)
Solving for Re:
• The effect of leverage on the risk of a firm’s securities can also be expressed in terms of beta:
MM Proposition II (MMII): Leverage and cost of capital
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• MM Proposition II: Leverage and the Cost of Capital
- In perfect capital markets, a firm’s WACC is independent of its capital structure and is equal to its cost
of equity of the unlevered firm.
Leverage ……………affect a firm’s cost of capital
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MM Proposition II (MMII): Leverage and cost of capital
= =
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• Why MMII: Why leverage does not affect a firm’s cost of capital?
- If a firm is unlevered, all of the free cash flows generated by its assets equal the cash flows received by its equity
holders. The firm asset cost of capital, the cost of unlevered equity, and the cost of capital are the same.
- If a firm is levered, because there is no tax, the firm pretax WACC (asset cost of capital RA) and after-tax WACC
(the cost of capital) are the same
- Therefore, a firm’ cost of capital:
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MM Proposition II (MMII): Leverage and cost of capital
= = + + +
= =
Leverage
Although debt has lower cost of capital than equity, as
the amount of debt increases, the cost of equity
increases, the net effect is that the firm’s WACC is
unchanged.
=
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CRICOS code 00025B
Example: A firm has only one investment project requiring an initial investment of $800 this year, the project will
generate cash flows of either $1400 or $900 next year, depending on whether the economy is strong or weak,
respectively. Both scenarios are equally likely. The project cost of capital is 15%.
a. What is the NPV of this project? What is the total value of this project? What is the total asset value of the firm after this
investment? What is the firm value after this investment?
What is the asset cost of capital of the firm?
b. To finance this project, the project is sold to investors as an all-equity firm (the project is financed using all equity). The
equity holders will receive all cash flows of the project after one year. How much the money can be raised in this way – that is,
what is the market value of unlevered equity? What is the total value of the firm?
What is the cost of (unlevered) equity (e.g., return on equity) of this firm? What is the cost of capital of this unlevered firm?
c. Suppose that the project is financed using both debt and equity, where the firm can borrow $500 at the risk-free rate of 5%,
what are the cash flows of levered equity in year 1? What is the value of the firm according to the MM? What is the initial
value of the firm’s levered equity?
What is the cost of (levered) equity of this firm (e.g., return on equity)? What is the cost of capital of this levered firm?
d. What do we learn from this example?
Example
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CRICOS code 00025B
Example: A firm has only one investment project requiring an initial investment of $800 this year, the project
will generate cash flows of either $1400 or $900 next year, depending on whether the economy is strong or
weak, respectively. Both scenarios are equally likely. The project cost of capital is 15%.
a. What is the NPV of this project? What is the total value of this project? What is the total asset value of the firm after this
investment? What is the firm value after this investment?
What is the asset cost of capital of the firm?
Example
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Project :15%
(Asset (x:15%)
CRICOS code 00025B
Example: A firm has only one investment project requiring an initial investment of $800 this year, the project will generate
cash flows of either $1400 or $900 next year, depending on whether the economy is strong or weak, respectively. Both
scenarios are equally likely. The project cost of capital is 5%.
b. If the project is financed using all equity. What is the value of the firm – that is, how much would investors be willing to
pay for the firm’ unlevered equity? What are the cash flows of unlevered equity in year 1?
What is the cost of (unlevered) equity or return on equity of this firm? What is the cost of capital of this unlevered firm?