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U of M ECON 1101 - MM theorem

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Slide 1Slide 2Slide 3Slide 4Slide 5Slide 6Slide 7Slide 8Slide 9Slide 10Slide 11Slide 12Slide 13Slide 14Slide 15Slide 16Slide 17Slide 18Slide 19Slide 20Slide 21Slide 22Slide 23Slide 24Slide 25Slide 26Slide 27Slide 28Slide 29Slide 30Slide 31Slide 32Slide 33Slide 34Slide 35Slide 36Slide 37Slide 38Slide 39Slide 40Slide 41Slide 42Slide 43Slide 44Slide 45Modigliani-Miller TheoremSummary of Chapter 14•The basic sources of long-term financing are:–Long-Term Debt–Common Stock–Preferred Stock•Common shareholders have voting rights, limited liability, and a residual claim on the corporation.•Bondholders have a contractual claim against the corporation.•Preferred stock has some of the features of debt and equity.•Firms need financing—most of it is generated internally.The Long-Term Financial GapSources of Cash Flow (100%)Internal cash flow (retained earnings plus depreciation) 68.3%Long-term debt and equity 31.7%Uses of Cash Flow (100%)Capital spendingNet working capital plus other usesInternal cash flowExternal cash flowFinancial deficit我我我我我我我我我我我我我我我我年年 年年年年 年年年年 年年年年 年年年年1998 6.26% 46.92% 22.88% 24.04%1999 5.51% 48.38% 24.38% 21.46%2000 5.95% 50.67% 23.82% 19.70%2001 5.59% 50.45% 26.80% 17.07%2002 6.71% 50.81% 29.15% 13.33%2003 9.43% 45.33% 29.47% 15.67%2004 10.93% 42.57% 31.20% 15.28%2005 12.16% 40.71% 32.24% 14.92%2006 12.36% 48.36% 28.18% 10.95%2007 17.26% 46.30% 21.86% 14.57%2008 20.00% 46.16% 25.56% 8.22%2009 19.28% 44.59% 26.76% 9.82%平平14.70% 46.04% 26.57% 12.75%?•Will the capital structure Affect The value of the firm ?Modigliani-Miller Theorem •Assumptions: –There are no transactions costs for buying and selling securities and there are no bid-ask spreads–The capital market is perfectly competitive (firms and investors are all price takers).–There are no bankruptcy costs.–There are no corporate or personal taxes.–All agents (firms and investors) have the same information.•Then: The value of the firm is independent of its capital structure. Financing choices are irrelevant!Pie theory•In general, financial transactions don’t create or destroy value as long as securities are sold at fair value. [Unless they affect taxes, investment decisions, etc.] •Value is created on the left-hand side of the balance sheet, not the right-hand side. •Your firm needs to raise $100 million. Does it matter whether you decide to issue debt or equity?•Leverage increases ROE and the expected returns to stockholders, but it also increases risk. •According to M&M, the two effects offset each other exactlyThe MM Propositions I & II (No Taxes)•Proposition I–Firm value is not affected by leverageVL = VU•Proposition II–Leverage increases the risk and return to stockholdersrs = r0 + (B / SL) (r0 - rB)rB is the interest rate (cost of debt)rs is the return on (levered) equity (cost of equity)r0 is the return on unlevered equity (cost of capital)B is the value of debtSL is the value of levered equityThe MM Proposition I (No Taxes)ULVV  BrEBITBreceive firm levered ain rsShareholdeBrBreceive sBondholderThe derivation is straightforward:BrBrEBITBB )(is rsstakeholde all toflowcash total theThus,The present value of this stream of cash flows is VL EBITBrBrEBITBB )(ClearlyThe present value of this stream of cash flows is VU15.4 The MM Proposition II (No Taxes)The derivation is straightforward:SBWACCrSBSrSBBr 0set Then rrWACC0rrSBSrSBBSBSSB by sidesboth multiply 0rSSBrSBSSSBrSBBSSBSB0rSSBrrSBSB00rrSBrrSBSB)(00 BSrrSBrr The Cost of Equity, the Cost of Debt, and the Weighted Average Cost of Capital: MM Proposition II with No Corporate TaxesDebt-to-equity RatioCost of capital: r (%)r0rBSBWACCrSBSrSBBr )(00 BLSrrSBrr rBSBExampleLeverage and risk •The required return and beta of equity goes up when leverage increasesβA, βE, βD and leverageWACC•Leverage shifts the firm towards ‘low cost’ debt financing, but it also raises the cost of equity. According to M&M, the two effects offset each other exactly. Ignoring tax effects, changing capital structure doesn’t affect the WACC. •Without taxes:Example•Your firm is all equity financed and has $1 million of assets and 10,000 shares of stock (stock price = $100). Earnings before interest and taxes next year will be either $50,000, $125,000, or $200,000. These earnings are expected to continue indefinitely. The payout ratio is 100%. •The firm is thinking about a leverage recapitalization, selling $300,000 of debt and using the proceeds to repurchase stock. The interest rate is 10%. •How would this transaction affect the firm’s EPS and stock price? Ignore taxes.No Arbitrage•investors in U can replicate the cash flows of investors in L and vice versa. Thus, the prices of U and L must be sameIf VU > VL•"Sell your holdings in firm U and buy a fraction α of firm L’s equity and debt."If VU < VL•"Sell your holdings in L, buy a fraction β of U’s equity, and borrow the amount βD at an annual rate r."Observations 我我我我 •Firms follow a pecking order •Different industries seem to have different target debt ratios• Stock issues are bad news, but debt issues are either neutral or good newsFinancing decisions(Two models ) •Pecking-order theory –Firms are worried primarily about selling undervalued shares. They sell equity only when they have no other choice, and there isn’t a specific target debt ratio. •Trade-off theory –Firms care mostly about taxes and distress costs. The tax benefits of debt dominate at low leverage, while distress costs dominate at high leverage. This trade-off leads to an optimal capital structure.Why is MM useful? •It tells us what is important … –Does debt affect investment decisions? –Does debt affect taxes? –Can equity be issued at fair value? –Are transaction costs or bankruptcy costs important? •And what isn’t … –Impact of debt on ROE and risk Cost of debt relative to the cost of equity (rD vs. rE)15.5 TaxesThe MM Propositions I & II (with Corporate Taxes)•Proposition I (with Corporate Taxes)–Firm value increases with leverageVL = VU + TC B•Proposition II (with Corporate Taxes)–Some of the increase in equity risk and return is offset by interest tax shieldrS = r0 + (B/S)×(1-TC)×(r0 -


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U of M ECON 1101 - MM theorem

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