Summary: Gov

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• 1 Capital structure: Static tradeoff

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• What determines firms' financing decisions?

  1. Debt (bank, loan, bond)
  2. Equity (share)

• What are the characteristics of debt and equity concerning: Voting power, Cash flows and Right to cash flow?

  VP: Debt no ; Equity yes
  CF: Debt interest ; Equity dividends, capital gains
  RTCF: Debt yes ; Equity no

• Is a firm's value affected by its capital structure?

  Goal = minimise cost of capital
  Rd = expected return debt holders
  Re = expected return equity holders
  Each year we need Rd*D + Re*E in percentages
  (Rd*D + Re*E)/(D + E) = Rd*(D/(D+E)) + Re*(E/(D+E))

• What is M&M Proposition I?

  The value of an asset remains the same, regardless of how the net operating cash flows generated by the asset are divided between different classes of investors (pie theory)

• What is the explanation for the M&M Proposition I?

  Interest rate on debt generally lower than required return on shares (WACC)

• How can the value of the firm be independent of leverage? (M&M Proposition II)

  The cost of equity of a levered firm is equal to the cost of equity of an unlettered firm + a financial risk premium, which depends on the degree of financial leverage

• What is the M&M Proposition II in formula?

  Re = R0 + (D/E)*(R0 - Rd)

• What are the M&M key assumptions? (5)

  - Individuals borrow at the same rate as corporations
  - Perfect capital market (no information asymmetry or transaction costs)
  - No taxes
  - No costs for financial distress
  - Fixed investment policy

• What role do taxes play in the classical system?

  Leverage will increase a firm's value because interest on debt is a tax-deductible expense resulting in an increase in the after-tax net cash flows to investors

• What role do taxes play with the M&M Proposition I?

  The value of a levered firm is equal to the value of an unlevered firm of the same risk class plus the present value of the tax saving