Capital Structure in a Perfect Market Chapter 14

Transcript:Capital Structure in a Perfect Market Chapter 14:
Capital Structure in a Perfect Market Chapter 14 outline Equity and or debt financing Return on levered equity Modigliani-Miller theorems: MM1: firm value not affected MM2: expected returns are affected Application to levered beta’s Thinking about cash Leverage and EPS dilution What is capital structure Composition of liabilities Need to finance a project…how much debt to raise/how much equity? Firms often recapitalize or change their capital structure using secondary market Does capital structure affects the value of assets? Focus on Cash-Flow rights Example Equity financing (issuing stock) Consider the project that requires an initial investment of $800 and generates risky cash flows one year from now. Cash flows are either $1400 or $900 with probability one half (0.5) depending on the state of the economy. -$800 $1400 $900 BOOM BUST NPV of the Project under Equity financing Investors require a 10% risk premium for holding equity in this firm due to the sensitivity of cash flows to the state of the economy (assume a risk free rate of 5%). What is the NPV of the project? Firm value under equity financing If the project is financed all with equity, how much will investors be willing to pay for the firms’ shares? Assuming that equity markets are competitive (remember we are considering perfect markets here) investors will break even on their investment. Equity holders are the residual claimants and are entitled to all future cash flows. They will be willing to pay Who benefits from positive NPV projects? The entrepreneur can sell the equity of the firm, cover the initial investment of $800 and remain with profit of $200. Notice – the value of the profit is determined by the NPV of the project. The returns earned by the investors are 40% in the good state and -10% in the bad state. Expected return is 15% - exactly as determined by the risk premium of 10%. Notice: here the risk of the project is the same as the risk of equity since there is no debt. Equity in a firm with no debt is called unlevered equity. Debt and Equity financing Suppose that $500 is raised via debt in addition to selling equity. Debt holders will require at the end of the year: Remember - Debt claims are senior to equity claims (debt holders are paid first and only if funds remain then equity holders are paid) Levered equity Equity in