The_Cost_of_Capital,_Corporation_Finance_The_Theory_….ppt
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The_Cost_of_Capital,_Corporation_Finance_The_Theory_….ppt
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TheCostofCapital,CorporationFinance&TheTheoryofInvestmentAmericanEconomicReviewMiller&Modigliani,1958PresentedbyMarcFuhrmannFebruary1,2007Agenda1.UniqueContributions2.ModelOverview3.PropositionsI&II4.ExtensionsofPropositionsI&II5.PropositionIII6.Implications7.Limitations&ExtensionsOmitted:
Relationto“Current”Doctrines,EmpiricsUniqueContributionsFirstformaluseofno-arbitrageargumentsAssumptionsledtothoroughexaminationoffinancialenvironment:
TaxesAgencyproblemsTransactionsandbankruptcycostsFrameworkwidelyusedinpractice(“WACC”)Simpleanalyticaltechnique,easilyunderstoodModel:
Overview(I)Simplemodeltovalueuncertainreturns:
All-equityfirmsbelongingtohomogeneousriskclassesk(onlyexpectedreturnsvaryacrossfirms)ThentheremustbeaproportionalityfactorthatrelatesstockpricetoexpectedreturnFactordenotedby1/pk,expectedreturnoffirmjdenotedbyxjThen,wehave:
andpkcanbethoughtofastherequiredrateofreturn.Model:
Overview(II)DebtFinancingAssumptionsAlldebtcashflowsarecertainBondsaretradedinaperfectmarketAllbondsareperfectsubstitutesBondssellatthesamepriceperdollarofexpectedreturnPropositionIOr,equivalently:
TheaveragecostofcapitalisindependentofitscapitalstructureProof(Sketch)No-arbitrageargument:
2firms,withidenticalexpectedreturnFirm1all-equity,Firm2hassomedebtSupposeV2V11.Supposefurtheraninvestorownss2dollarsinfirm22.ReturnY2isafractionofXrD2:
3.Nowsupposetheinvestorsellstheshareandacquiresinsteads1=(X-rD2).Thenewportfoliothusyields:
4.SinceV2V1,wemusthaveY1Y2=Leveredfirmscannotcommandapremiumoverunleveredfirms.Note:
KeyassumptionisthatinvestorscanborrowatthesamerateasfirmPropositionIICapitalizationratepforpureequitystreaminclasskSpreadbetweenpandrDebt/EquityRatioExpectedyieldofashareofstockinfirmjProofSimplealgebra:
bydefinitionofijbyPropositionISubstituteandsimplifytoobtain:
ExtensionsAllowfor:
1.Corporatetaxationwithdeductibleinterestpayments2.Multipletypesofbondsandinterestrates3.MarketimperfectionsExtensionI:
TaxationAveragecorporatetaxrateShareholdersexpectednetincomeTaxableincomeResults:
Proposition1becomes:
Proposition2becomes:
ExtensionII:
PluralityofBondsPropositionIremainsunaffectedPropositionIIhastobemodifiedProofofCase1RecallthatandNow,letthefirmborrowIdollarsforaninvestmentyieldingp*.Itfollowsthat:
Andthereforewehave:
andandfinallyImplicationsThesourceoffundsisirrelevantwithrespecttothequestionofwhetherornotaninvestmentisworthwhile.Thereremainotherreasonstopreferonetypeoffinancingoveranother:
AsymmetricinformationTaxconsiderationsManagementinterest(notalwaysinconflictwithowners)Limitations&ExtensionsThemodelprovidesaframeworkforcapital-structureandinvestmentdecisionsItcanbeextendedinmanydirectionsmorerealisticassumptionsgeneralequilibriumcontextEmpiricaltestingisneededCountlessextensionsandtestsoverthepast50years1826citationsaccordingtoGoogleScholar
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