Chapter 14 Capital Structure in a Perfect MarketChapter OutlineLearning ObjectivesLearning Objectives (continued)Learning Objectives (continued)Learning Objectives (continued)14.1 Equity Versus Debt FinancingFinancing a Firm with EquityTable 14.1 The Project Cash FlowsFinancing a Firm with Equity (continued)Financing a Firm with Equity (continued)Financing a Firm with Equity (continued)Financing a Firm with Equity (continued)Table 14.2 Cash Flows and Returns for Unlevered EquityFinancing a Firm with Equity (cont'd)Financing a Firm with Debt and EquityFinancing a Firm with Debt and Equity (continued)Slide 18Financing a Firm with Debt and Equity (continued)Financing a Firm with Debt and Equity (continued)Financing a Firm with Debt and Equity (continued)Financing a Firm with Debt and Equity (continued)The Effect of Leverage on Risk and ReturnTable 14.4 Returns to Equity with and without LeverageThe Effect of Leverage on Risk and Return (continued)The Effect of Leverage on Risk and Return (continued)Slide 27The Effect of Leverage on Risk and Return (continued)The Effect of Leverage on Risk and Return (continued)The Effect of Leverage on Risk and Return (continued)Textbook Example 14.1Textbook Example 14.1 (continued)14.2 Modigliani-Miller I: Leverage, Arbitrage, and Firm ValueSlide 34Slide 35MM and the Law of One PriceHomemade LeverageHomemade Leverage (continued)Table 14.6 Replicating Levered Equity Using Homemade LeverageHomemade Leverage (continued)Slide 41Homemade Leverage (continued)Textbook Example 14.2Textbook Example 14.2 (continued)Slide 45Slide 46Slide 47Slide 48Slide 49Textbook Example 14.4Capital Budgeting and the Weighted Average Cost of CapitalSlide 52Slide 53Figure 14.1 WACC and Leverage with Perfect Capital MarketsAlternative Example 14.5Alternative Example 14.5 (continued)Alternative Example 14.5 (cont’d)Alternative Example 14.5 (continued)Computing the WACC with Multiple SecuritiesTextbook Example 14.6Textbook Example 14.6 (continued)Levered and Unlevered BetasLevered and Unlevered Betas (continued)Levered and Unlevered Betas (continued)Textbook Example 14.7Textbook Example 14.7 (continued)Textbook Example 14.8Textbook Example 14.8 (continued)14.4 Capital Structure Fallacies14.4 Capital Structure Fallacies (continued)14.4 Capital Structure Fallacies (continued)14.4 Capital Structure Fallacies (continued)14.4 Capital Structure Fallacies (continued)Figure 14.2 LVI Earnings per Share with and without LeverageTextbook Example 14.9Textbook Example 14.9 (continued)Equity Issuances and DilutionEquity Issuances and Dilution (continued)Equity Issuances and Dilution (continued)Equity Issuances and Dilution (continued)Equity Issuances and Dilution (continued)Equity Issuances and Dilution (continued)14.5 MM: Beyond the PropositionsChapter QuizChapter QuizChapter 14Capital Structure in a Perfect MarketCopyright ©2014 Pearson Education, Inc. All rights reserved.Chapter Outline14.1 Equity versus Debt Financing14.2 Modigliani-Miller I: Leverage, Arbitrage, and Firm Value14.3 Modigliani-Miller II: Leverage, Risk, and the Cost of Capital14.4 Capital Structure Fallacies14.5 MM: Beyond the PropositionsCopyright ©2014 Pearson Education, Inc. All rights reserved.Learning Objectives1. Define the types of securities usually used by firms to raise capital; define leverage.2. Describe the capital structure that the firm should choose.3. List the three conditions that make capital markets perfect.Copyright ©2014 Pearson Education, Inc. All rights reserved.Learning Objectives (continued)4. Discuss the implications of MM Proposition I, and the roles of homemade leverage and the Law of One Price in the development of the proposition.5. Calculate the cost of capital for levered equity according to MM Proposition II.6. Illustrate the effect of a change in debt on weighted average cost of capital in perfect capital markets.Copyright ©2014 Pearson Education, Inc. All rights reserved.Learning Objectives (continued)7. Calculate the market risk of a firm’s assets using its unlevered beta.8. Illustrate the effect of increased leverage on the beta of a firm’s equity.9. Compute a firm’s net debt.10. Discuss the effect of leverage on a firm’s expected earnings per share.Copyright ©2014 Pearson Education, Inc. All rights reserved.Learning Objectives (continued)11. Show the effect of dilution on equity value.12. Explain why perfect capital markets neither create nor destroy value.Copyright ©2014 Pearson Education, Inc. All rights reserved.14.1 Equity Versus Debt Financing•Capital Structure–The relative proportions of debt, equity, and other securities that a firm has outstandingCopyright ©2014 Pearson Education, Inc. All rights reserved.Financing a Firm with Equity•You are considering an investment opportunity. –For 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.Copyright ©2014 Pearson Education, Inc. All rights reserved.Table 14.1 The Project Cash FlowsCopyright ©2014 Pearson Education, Inc. All rights reserved.Financing a Firm with Equity (continued)•The project cash flows depend on the overall economy and thus contain market risk. As a result, investors demand a 10% risk premium over the current risk-free interest rate of 5% to invest in this project.•What is the NPV of this investment opportunity?Copyright ©2014 Pearson Education, Inc. All rights reserved.Financing a Firm with Equity (continued)•The cost of capital for this project is 15%. The expected cash flow in one year is:–½($1400) + ½($900) = $1150.•The NPV of the project is:Copyright ©2014 Pearson Education, Inc. All rights reserved.Financing a Firm with Equity (continued)•If you finance this project using only equity, how much would you be willing to pay for the project?•If you can raise $1000 by selling equity in the firm, after paying the investment cost of $800, you can keep the remaining $200, the NPV of the project NPV, as a profit.Copyright ©2014 Pearson Education, Inc. All rights reserved.Financing a Firm with Equity (continued)•Unlevered Equity–Equity in a firm with no debt•Because there is no debt, the cash flows of the unlevered equity are equal to those of the project.Copyright ©2014 Pearson Education, Inc. All rights reserved.Table 14.2 Cash Flows and Returns for Unlevered EquityCopyright ©2014 Pearson