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10 Cards in this Set
- Front
- Back
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What is a company's capital structure? |
It is a company's debt-equity split. |
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What is proposition I under Modigliani-Miller (MM)? |
In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure. |
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What does MM ignore (i.e., what are the reasons why capital structure can possibly matter)? |
1. market completeness - law of one price / no arbitrage opportunities (Eg, inverted bond; not sure how to price)
2. information asymmetries - perceptions; we can glean information about issuer from its capital structure (e.g., confidence); "signalling"
3. bankruptcy costs - debt means greater probability of bankruptcy (a debt payment regularly due); further debt gets more expensive the more likely a firm is to go bankrupt,
4. tax bills - can deduct interest payments
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What does MM ignore (i.e., what are the reasons why capital structure can possibly matter)? (Cont'd) |
5. effort effects (aka moral hazard) - giving management equity makes them work harder
6. fees/transaction costs - e.g., for raising funds (eg, of an IPO)
7. competitive distortions - investors and firms can trade the same set of securities at competitive market prices equal to PV of FCF |
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Economic distress |
Economically efficient to close firm (i.e., value liquidated is higher than as going concern) |
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Financial distress |
The firm is not generating enough cash to service debt, so lenders have the power to force liquidation |
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Debt overhang |
A debt burden that is so large that an entity cannot obtain new investment to finance future projects, even those that are profitable enough to enable it to reduce its indebtedness over time. |
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What is homemade leverage? |
When investors use leverage in their own portfolios to adjust the leverage choice made by the firm ( Eg, borrow money to buy shares) |
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The first Modigliani Miller (MM) Proposition states that |
, in a Modigliani Miller world (q.v.), the way that a corporation’s value is unaffected by its capital structure; |
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the second MM Proposition says that |
the corporate cost of capital is unaffected by capital structure. |
