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Transcript
The value of a firm from two angles Assets Value of cash flows from firm’s real assets and operations Value of Firm LO1 Liabilities and Stockholder’s Equity Market value of debt Market value of equity Value of Firm © 2012 McGraw-Hill Ryerson Limited Chapter 16 -1 A firm’s capital structure is the mix of debt and equity its financial managers choose Does the choice of capital structure affect the value of a firm Modigliani and Miller (MM) ◦ When there are no taxes and well functioning capital markets exist, the market value of a company does not depend on its capital structure ◦ In other words, managers cannot increase firm value by changing the mix of securities used to finance the company LO1 © 2012 McGraw-Hill Ryerson Limited Chapter 16 -2 MM Assumptions: ◦ Capital markets have to be “well functioning” Investors can borrow/lend on the same terms as firms Capital markets are efficient ◦ There are no taxes or costs of financial distress LO1 Example: in the next few slides, it is shown how the River Cruise company is operating now and how can it change its structure. At the end, it is shown that whatever it achieves by changing its structure, can be replicated by the shareholders themselves. MM called it the ‘home-made leverage’. © 2012 McGraw-Hill Ryerson Limited Chapter 16 -3 The River Cruise example: Current Structure Number of shares 100,000 Price per share $10 Market Value of Shares $ 1 million Outcome Operating Income Earnings per share Return on Shares LO1 Value of firm = $1 mill State of the Economy Slump $75,000 $.75 7.5% Expected 125,000 1.25 12.5% Boom 175,000 1.75 17.5% © 2012 McGraw-Hill Ryerson Limited Chapter 16 -4 The River Cruise example: Proposed Structure Issue $500,000 of debt with a 10% coupon and use the funds to repurchase 50,000 shares at $10 apiece Number of shares Price per share 50,000 $10 Market Value of Shares 500,000 Market val ue of debt 500,000 Value of firm = D+E= $500,000 + $500,000 = $1 mill LO1 © 2012 McGraw-Hill Ryerson Limited Chapter 16 -5 Earnings and returns per share with debt State of the Economy Operating Income Interest Equity earnings Earnings per share Return on shares LO1 Slump Expected Boom $75,000 125,000 175,000 $50,000 50,000 50,000 $25,000 75,000 125,000 $.50 1.50 2.50 5% 15% 25% © 2012 McGraw-Hill Ryerson Limited Chapter 16 -6 If the firm did not borrow, but the shareholders borrowed $10 to buy one more share. This would make them have a debt of 50%, the same as that of the proposed firm structure. Outcome State of the Economy Slump Expected Boom Earnings on two shares $1.50 2.50 3.50 LESS : Interest @ 10% $1.00 1.00 1.00 Net earnings on investment $.50 1.50 2.50 Return on $10 investment 5% 15% 25% LO1 © 2012 McGraw-Hill Ryerson Limited Chapter 16 -7 How borrowing affects risk and return All Equity Financing Firm Value: $1 million After Restructuring Debt: $500,000 Equity: $500,000 Even though the value of the firm remains unchanged, shareholders of the levered firm face a higher risk and therefore demand a higher return LO1 © 2012 McGraw-Hill Ryerson Limited Chapter 16 -8 Restructuring does not affect operating income ◦ The operating risk, or business risk, of the firm is unchanged ◦ However, with more debt in the capital structure, the EPS becomes more risky. The financial risk of the firm increases. MM’s Proposition II ◦ The required return on a firm’s equity increases as the firm’s debt-equity ratio increases D requity rassets rassets rdebt E LO1 © 2012 McGraw-Hill Ryerson Limited Chapter 16 -9 MM’s proposition II with constant rDebt Note: rdebt need not be constant LO1 © 2012 McGraw-Hill Ryerson Limited Chapter 16 -10