MM定理

So debt financing should be used But cash raised will increases assets
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When will capital structure matter?

Perfect capital market: the benchmark

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Example
The Project Cash Flow Date 0 Strong Economy ½ -$800 $1400 Date 1 Weak Economy ½ $900
1. 2. 3. 4.
Required rate of return=r(f)+risk premium=5%+10% =15% PV(equity cash flow)=1/2*(1400+900)/1.15 = $1000 NPV=-800+1000 = $200 IRR=1150/800-1=43.75%.
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Return to Equity with and without Leverage
Date 0 Initial Value Debt Levered Equity Unlevered Equity Note:
1. 2.
Date 1: Cash Flows Strong 525 875 $1400 Weak 525 375 $900 Strong 5% 75% 40%
E=1/2*(875+375)/1.15=$543?
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Why not borrow even more?
Values and Cash Flows for Debt and equity of the Levered Firm Date 0 Initial Value Debt Levered equity Firm $800 E=? Strong $840 $560 $1400 Date 1 Weak $840 $60 $900
Asset substitution: shareholders have incentives to invest in risky negative-NPV projects. Debt overhang: shareholders have incentives to invest in risky negative-NPV projects. Cash out and pay dividend. Debt maturity and covenants
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Cost of Capital

E+D=U=A
E * RE + D * RD = U *RU


E/(E+D) * RE + D/(E+D) * RD = RU
RE = RU + (D/E) * (RU-RD)


MM theorem II: A firms’ WACC is independent of its capital structure.
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MM theorem and common “mistakes”

Is debt cheaper than equity?

Increasing leverage raises the risks of the levered equity

Equity issuance dilute existing shareholder’s ownership
VL=VU+PV(interest tax shield)-PV(financial distress costs)

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Agency costs of Leverage

Facing financial distress, conflicts of interests between debt and equity holders. Shareholders may exploit debt holders.
Capital Structure
Jianguo Xu Beijing University Spring 2011
The One Billion $ Question
A firm need to finance for a project, whether to issue debt, or equity, or … ?
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Interest tax shield

Interest is tax deductible. Dividend is not.
Interest tax shield=corporate tax rate * Interest payment


Cash flow to investors with leverage=Cash flow to investors without leverage + interest tax shield

Economic distress

Costs of bankruptcy

Bankruptcy code:

Liquidation Reorganization

Direct costs (workout, prepackaged bankruptcy): Indirect costs



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MM theorem

In the 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.
E=1/2*(560+60)/1.15≈$270
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Leverage increases firm value?

Law of one price

E=1000-500=$500

What is wrong with the above calculation?

Risk of the equity
Loss of customers, suppliers, employees, receivables, fire sale of assets, delayed liquidation
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Tradeoff Theory

Tradeoff between interest tax shield of debt and cost of bankruptcy
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Financing Option 1: Unlevered Equity
Cash Flows and Returns for Unlevered Equity Date 0 Initial Value $1000 Date 1: Cash Flows Strong $1400 Weak $900 Date 1: Returns Strong 40% Weak -10%
Q: What is the implied rate of return for equity investors?
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Financing Option 2: Levered Equity
Values and Cash Flows for Debt and equity of the Levered Firm Date 0 Initial Value Debt Levered equity Firm $500 E=? Strong $525 $875 $1400 Date 1 Weak $525 $375 $900
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Replicating Unlevered Equity by Holding Debt and Equity
Date 0 Initial Cost Debt Levered Equity Unlevered Equity $500 $500 $1000 Date 1: Cash Flows Strong $525 $875 $1400 Weak $525 $375 $900
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Motivating managers: agency benefits of leverage

Management entrenchment
Concentration of ownership


Work effort, corporate perks

Free cash flow hypothesis Financial distress and firing (motivating) of managers
MM theorem and the separation principle: if securities are fairly priced, then buying and selling securities has a NPV of zero and, therefore, should not change the value of the firm.
Date 1: Returns Weak 5% -25% -10% Expected return 5% 25% 15%来自500 500 $1000
The “risk” of equity increases with leverage, so is the expected return. The average cost of capital remain unchanged. Debt is NOT cheaper!