Why should shareholders in a firm care about maximizing the value of the entire firm and not only about increasing the value of their shares?
Changes in capital strucutre benefit the shareholders IF AND ONLY IF the value of the firm increases
What kind of capital strucutre should a financial manager choose?
they should choose the capital strucutre with the highest firm value because this capital structure will be most beneficial to the firm's shareholders
(remember: Goal of financial management: increase value of shares)
Leverage refers to the use of debt (borrowed funds) to amplify returns from an investment or project.
leverage can magnify gains but also losses to shareholders (increased risk)
Investors use leverage to multiply their buying power in the market.
Companies use leverage to finance their assets—instead of issuing stock to raise capital, companies can use debt to invest in business operations in an attempt to increase shareholder value.
When one refers to a company, property, or investment as "highly leveraged," it means that item has more debt than equity.
Explain the Modigliani and Miller Proposition I (without taxes)
the value of the levered firm is the same as the value of the unlevered firm
basically: the value of the firm is always the same under different capital strucutres
This is the case because investors can use homemade leverage to change the capital structure and there are no taxes
What is homemade leverage and under which assumptions does it work?
- personal borrowing or lending in order to increase/ decrease leverage
- used to recreate the effects of corporate leverage
- ex.: buying shares in an unlevered firm with a personal loan -> increase leverage
1. coorportions and individuals can borrow and lend at the same interest rate
2. no taxes
Explain the Modigliani and Miller Proposition II (without taxes)
The required return on equity is a linear function of the firm's debt to equity ratio.
-> risk to equity holders rises with leverage
(remember: increasing risk means increasing potential return)
-> required return to equity holders rises with leverage
implication of MM I:
a firm's weighted average cost of capital is (r_wacc) is indipendent on the capital structure of the firm
r_S: expected return on equity
r_B: cost of debt
r_0: cost of capital of an all-equity (unlevered) firm
B: market value of debt
S: market value of equity
What re the implications of MM I (without taxes)
1. share price of a firm is indipendant of its capital structure
2. weighted average cost of capital of a firm is indipendant of its capital structure