• Document: Chapter 17 Corporate Capital Structure Foundations (Sections 17.1 and Skim section 17.3.)
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Chapter 17 – Corporate Capital Structure – Foundations (Sections 17.1 and 17.2. Skim section 17.3.) The primary focus of the next two chapters will be to examine the debt/equity choice by firms. In particular, we will discuss possible advantages and disadvantages to debt versus equity financing. In Chapter 17, we will: 1) Learn the perfect capital market assumptions (needed to demonstrate capital structure irrelevance). 2) Learn the arbitrage proof for capital structure irrelevance. 3) Learn how investors can manipulate capital structure of any firm to suit their own tastes. 4) Review the effect of leverage changes on the return on equity, return on debt, return on assets, and WACC (Chapter 9 stuff). The purpose of the discussion of this chapter is to lay the foundations for a higher level (real world) discussion in Chapter 18. ****************************************************************************** Capital Structure Analysis in a Nutshell • If the firm is all equity, the firm's stockholders are the owners of 100% of the firm's cash flows. Cash flows can be: Paid to stockholders as a dividend (or stock repurchase), or Reinvested by the corporation in projects, or Put in a bank checking account or invested in securities • If there is debt and equity (and perhaps other types of securities such as preferred stock, convertible debt, etc.) on the right-hand-side of its balance sheet, then the firm's cash flows must be split among the various claimants. • Capital structure analysis attempts to find the particular combination of debt and equity (and other types of securities) that maximizes firm value (and stockholder value). • Based on a certain set of assumptions discussed below, a firm's capital structure decision is irrelevant. In other words, a firm cannot increase or decrease its value by making changes to the right-hand-side of its balance sheet. • Starting with the foundation of capital structure irrelevance, Chapter 18 will incorporate ‘real world’ assumptions and examine the effects of these ‘real world’ assumptions on the firm's capital structure decision. Chapter 17 "Perfect Capital Market" Assumptions: 1. No income taxes. (Therefore, no income tax deduction for interest payments.) 2. No bankruptcy costs. (No attorney/accountant/trustee fees or other costs from going bankrupt.) 3. No transaction costs. (The is no cost to the corporation for issuing and repurchasing securities. Investors can also buy and sell securities for free.) 4. Unlimited borrowing and lending at the risk-free interest rate for corporations and investors. 5. No asymmetric information. (Outside investors know as much as corporate insiders.) 6. Managers and firm employees work to maximize stockholder wealth. Also, managers and employees of the firm are not affected by the amount of debt versus equity in a firm. (For instance, managers and employees do not let the amount of leverage affect the criteria they use to select projects, how they manage the firm’s assets, etc.) 1 Modigliani and Miller (1958) Proposition 1: With the above assumptions, the value of the firm (in equilibrium) is independent of the proportion of debt and equity in the firm's capital structure. Stating the proposition in another way: If two firms (Firm A and Firm B) have identical assets, then with perfect capital markets: DA + EA = DB + EB If not identical, it is possible to earn a risk-free, zero cash investment, arbitrage profit. More specifically, if the market values of these two firms are not identical, then it is possible to make a series of investments in the firm’s securities that require no net cash outlay and have no risk, but pays the investor a positive cash flow. Four examples of an arbitrage profit (all cash flows are risk free): 0 1 2 3 4 5 6 → $0 $1 $1 $0 $0 $1 $1 $1 $1 $1 $1 → $1 $0 $0 $0 $0 $0 $0 → Earning money because you make a cash investment, or take on some risk, is consistent with market equilibrium. However, in equilibrium, a risk-free investment that requires no cash outlay should not pay a positive cash flow to the investor. If the market is out of equilibrium (and arbitrage profits are available), then investors taking advantage of the arbitrage opportunity would quickly force prices back into equilibrium (and eliminate the arbitrage opportunity). A simple example of an (almost) risk-free, zero-cash investment, arbitrage profit. Gold purchaser on 42nd Street in New York says that he will buy gold at $301 per ounce. Gold seller on 43rd Street in New York says that she wil

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