1. Capital Structure I Capital Structure in a perfect market

Equity is the residual claimant:

• As an equity investor I hope for dividends or share price increases

• As an equity investor I‘ll be „the last in line to receive money“, both in normal times (profit / dividend) and insolvency

• As a debt investor, I hope for bond price increases, but mainly I will receive a predetermined interest rate

• Debt investors sleep better

Aktiva = Liquide Mittel + Sachwerte

Passiva = Eigenkapital + Wert der Optionen

Sachwerte = Eigenkapital + Wert der Optionen - Liquide Mittel

Relative proportions of debt, equity and other securities that a firm has outstanding to finance its assets and operations

1. Issue share to increase equity

2. Raise debt capital

Equity in a firm that has outstanding debt.

Promised payments to debt holders must be made before any payments to equity holders.

Equity is the residual claimant:

• As an equity investor I hope for dividends or share price increases

• As an equity investor I‘ll be „the last in line to receive money“, both in normal times (profit/dividend) and insolvency

• As a debt investor, I hope for bond price increases, but mainly I will receive a predetermined interest rate

• Debt investors sleep better

Because of the law of one price. The combined values of debt and equity must be the cash flow of the project. Otherwise, there are arbitrage opportunities.

All financial transactions have a NPV of zero and neither create nor destroy value.

When the “law of one price” applies, the firm’s overall value (the sum of the market values of debt and equity) will not change when debt replaces equity.

The systematic risk. It is calculated by subtracting the return in a bad environment from the return in a good environment.

The risk premium is the market return - the risk free return and it encompasses the compensation for the additional risk the investor takes on

No. It merely changes te allocation of cash flows between debt and equity, without altering the total cash flows of the firm

1. Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.

2. There are no taxes, transaction costs, or issuance costs associated with security trading.

3. A firm’s financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them.

MM Proposition I: In a perfect capital market, the total value of a firm’s securities 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.

When investors use leverage in their own portfolios to adjust the leverage choice made by the firm, we say that they are using homemade leverage

A market value balance sheet is similar to an accounting balance sheet, with two important distinctions.

First, all assets and liabilities of the firm are included—even intangible assets such as reputation, brand name, or human capital that are missing from a standard accounting balance sheet.

Second, all values are current market values rather than historical costs.

→ Value is only created by a firm’s choice of assets and investments (NPV>0)

When a firm repurchases a significant percentage of its outstanding shares by taking on debt.

In the end, the savings from the low expected return on debt, the debt cost of capital, are exactly offset by a higher equity cost of capital, and there are no net savings for the firm.

MM Proposition II: The cost of capital of levered equity increases with the firm’s market value debt- equity ratio,

That is, with perfect capital markets, a firm’s WACC is independent of its capital structure and is equal to its equity cost of capital if it is unlevered, which matches the cost of capital of its assets.

But even though the debt and equity costs of capital both rise when lever- age is high, because more weight is put on the lower-cost debt, the WACC remains constant.

Although debt has a lower cost of capital than equity, leverage does not lower a firm’s WACC. As a result, the value of the firm’s free cash flow evaluated using the WACC does not change, and so the enterprise value of the firm does not depend on its financing choices. This observation allows us to answer the questions posed for the CFO of EBS at the beginning of this chapter: With perfect capital markets, the firm’s weighted average cost of capital, and therefore the NPV of the expan- sion, is unaffected by how EBS chooses to finance the new investment.

Unlevered Beta = Asset Beta

It is the weighted average of its equity and debt beta

When a firm changes its capital structure without changing its investments, its unlevered beta will remain unaltered. However, its equity beta will change to reflect the effect of the capital structure change on its risk.

Holding excess cash has the opposite effect of leverage on risk and return. From this standpoint, we can view cash as negative debt.

A firm’s net debt is equal to its debt less its holdings of cash and other risk-free securities. We can compute the cost of capital and the beta of the firm’s business assets, excluding cash, by using its net debt when calculating its WACC or unlevered beta.

When earnings are low, leverage will cause EPS to fall even further than it does otherwise would have.

The same fluctuation in EBIT will lead to greater fluctuation in EPS once leverage is introduced.

The expected EPS rises with leverage, the risk of EPS also increases. Therefore an increase in EPS is necessary to compensate shareholders for the additional risk they are taking

In general, as long as the firm sells the new shares of equity at a fair price, there will be no gain or loss to shareholders associated with the equity issue itself. The money taken in by the firm as a result of the share issue exactly offsets the dilution of the shares. Any gain or loss associated with the transaction will result from the NPV of the investments the firm makes with the funds raised.6

With perfect capital markets, financial transactions neither add nor destroy value, but instead represent a repackaging of risk (and therefore return).