MM Proposition

Download MM Proposition

Post on 07-Dec-2015

215 views

Category:

Documents

0 download

Embed Size (px)

DESCRIPTION

Capital Structure, MM propositions I and II, with and without taxes

TRANSCRIPT

<ul><li><p>Corporate Finance Lecture Note 1*</p><p>Valuation under MM</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*MM Proposition I (No Taxes)</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*RoadmapOverview of Modigliani-Miller Propositions IHomemade Leverage and Leveraged Equity Assumption of Modigliani-Miller Propositions IModigliani-Miller Propositions I</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*Capital Structure and the PieThe value of a firm is defined to be the sum of the value of the firms debt and the firms equity.V = D + E</p><p> If the goal of the firms management is to make the firm as valuable as possible, then could the firm pick the debt-equity ratio that makes the pie as big as possible? Value of the FirmSDE</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*MM Proposition I (No Taxes) Debt Policy is Irrelevant </p><p>MM Proposition I (No Taxes)AssumptionIntuitioncapital structure is irrelevant</p><p>SEDSBEBD=</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*Modigliani-Miller Proposition I (No Taxes)The total value of the securities issued by a firm is independent of the firms choice of capital structure.The firms value is determined by its real assets and growth opportunities, not by the types of securities it issues.</p><p>*This is the very step Modigliani-Miller results, and it holds in an idealized world.</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*Assumptions under Modigliani-Miller Proposition I1. Capital structure does not affect investment policy2. No taxes (corporate taxes, personal taxes, etc)3 Bankruptcy is costless4. Managers maximized shareholders (E) value, not total firm value (the Pie, E+D).5. Perfect and complete capital markets6. Symmetric information (No black box)</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*IntuitionWe can create a levered or (un)levered position by adjusting the trading in our own account.This homemade leverage suggests that capital structure is irrelevant in determining the value of the firm:VL = VU</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*Homemade Leverage: An ExampleRecessionExpected ExpansionEPS of Unlevered Firm$2.50$5.00$7.50Earnings for 40 shares$100$200$300Less interest on $800 (8%)$64$64$64Net Profits$36$136$236ROE (Net Profits / $1,200)3.0%11.3%19.7%We are buying 40 shares of a $50 stock, using $800 in margin. We get the same ROE as if we bought into a levered firm.</p><p>Our personal debt-equity ratio is:</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*Homemade (Un)Leverage: An ExampleRecessionExpected ExpansionEPS of Levered Firm$1.50$5.67$9.83Earnings for 24 shares$36$136$236Plus interest on $800 (8%)$64$64$64Net Profits$100$200$300ROE (Net Profits / $2,000)5%10%15%Buying 24 shares of an otherwise identical levered firm along with some of the firms debt gets us to the ROE of the unlevered firm.This is the fundamental insight of M&amp;M</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*In-Class Exercise</p><p>Firm has a total market value of $150,000 under no debt. EBIT (Earnings before interest and taxes) is $14,000 under normal case and is 40% higher if in expansion and is 70% lower when it is recession. There are currently 2,500 shares outstanding.1. Calculate EPS (Earnings per share)2.Repeat 1 when the firms issues $60,000 to buyback the shares in the open market. </p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*In-Class ExerciseShares repurchased = 1,000 shares ?</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*Summary: MM Proposition I (No Taxes)We can create a levered or unlevered position by adjusting the trading in our own account.This homemade leverage suggests that capital structure is irrelevant in determining the value of the firm:VL = VU</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*MM Proposition II (No Taxes) </p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*RoadmapMM Proposition II (No Taxes)Equity risk increases wit the level of debtProofEconomic Intuition</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*Modigliani-Miller Proposition II (No Taxes)We denote the expected returns on assets, debt and equity by RA, RD , and RE , respectively. Then</p><p>Where D and E are the market values of debt and equity and </p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*Modigliani-Miller Proposition II (No Taxes)Proof:Let total market value of the assets, debt, and equity as A, D, and E, respectively </p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*MM Proposition II (No Taxes)Debt-to-equity RatioCost of capital: R (%)RARDRARD</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*MM Proposition II (No Taxes)1. Increasing the debt level does not affect the riskiness of the assets, but it does increase the riskiness of the equityIn the same firm, RD is always less than RE,This is because the debt has a higher priority and this is less risky. But the weighted sum of the returns of debt and equity is always a constant, and is equal to the return on assets, RA</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*In-Class ExercisePlease evaluate the following argument:</p><p> Equity is cheap because the firm does not have to pay investors any dividends if it does not want to.</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*In-Class Exercise: P/E ratioFirm X has expected revenues (or EBIT) of $5 million per year. It has a capital structure with $10 million in risk-free debt paying 4% and 4 million shares which sell at $10/share. This implies that firm value is $50 million. 1. What are the RA, RD , and RE, and EPS2. What is the P/E ratio?</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*In-Class Exercise: P/E ratioRA= $5 /(40+10)=10%</p><p>EPS=(5-10*0.04)/4=$1.15/shareP/E=10/1.15=8.7</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*ContinuedThe CEO decides to boost the P/E ratio in order to increase shareholder value. The firm issues 1 million new shares at $10/share and uses the proceeds to buy back all its debt. What are the EPS and P/E ratio?Can you evaluate the firms based on the P/E ratio and EPS?</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*In-Class Exercise: P/E ratioEPS=(5-)/5=$1/shareP/E=10/1=10In evaluating firms, we must focus on expected cash flows and risk, not P-E ratios and earnings per share</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*In-Class Exercise: Share repurchaseThe firm now repurchases 20 shares. Can you evaluate the firms based on the P/E ratio and EPS?</p><p>ProfitSharesEPSP/E ratioShare price (per share)5001005840</p><p>ProfitSharesEPSP/E ratioShare price (per share)500806.256.440</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*Corporate Taxes and Firm Value MM Propositions I and II (with Corporate Taxes) </p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*RoadmapCorporate Tax ShieldMM Propositions I and II (with Taxes)The implication of optimal debt level under MM Propositions I and II (with Taxes)</p><p>Corporate Finance Lecture Note 1</p></li><li><p>Corporate Finance Lecture Note 1*Capital Structure &amp; Corporate TaxesThe tax deductibility of interest increases the total distributed income to both bondholders and shareholders.</p><p>Corporate Finance Lecture Note 1</p><p>3.6</p><p>Inflation19001901190219031904190519061907190819091910191119121913191419151916191719181919192019211922192319241925192619271928192919301931193219331934193519361937193819391940194119421943194419451946194719481949195019511952195319541955195619571958195919601961196219631964196519661967196819691970197119721973197419751976197719781979198019811982198319841985198619871988198919901991199219931994199519961997199819992000200120022003</p><p>19000.61Inflation0.611.221.21.791.7500.573.291.11-1.641.672.191.071.991.041.9311.618.5320.514.792.27-10.65-2.562.63-0.233.85-1.49-2.08-0.970.2-6.03-9.52-10.30.512.032.991.213.1-2.78-0.480.969.729.293.162.112.2518.169.012.71-1.85.795.870.880.62-0.50.372.863.021.761.51.480.671.221.651.191.923.353.044.726.115.493.363.418.812.27.014.816.779.0313.3112.48.943.873.83.953.771.134.414.424.656.113.062.92.752.672.543.321.71.612.683.391.552.381.9</p><p>19011.22</p><p>19021.2</p><p>19031.79</p><p>19041.75</p><p>19050</p><p>19060.57</p><p>19073.29</p><p>19081.11</p><p>1909-1.64</p><p>19101.67</p><p>19112.19</p><p>19121.07</p><p>19131.99</p><p>19141.04</p><p>19151.93</p><p>191611.6</p><p>191718.53</p><p>191820.5</p><p>191914.79</p><p>19202.27</p><p>1921-10.65</p><p>1922-2.56</p><p>19232.63</p><p>1924-0.23</p><p>19253.85</p><p>1926-1.49</p><p>1927-2.08</p><p>1928-0.97</p><p>19290.2</p><p>1930-6.03</p><p>1931-9.52</p><p>1932-10.3</p><p>19330.51</p><p>19342.03</p><p>19352.99</p><p>19361.21</p><p>19373.1</p><p>1938-2.78</p><p>1939-0.48</p><p>19400.96</p><p>19419.72</p><p>19429.29</p><p>19433.16</p><p>19442.11</p><p>19452.25</p><p>194618.16</p><p>19479.01</p><p>19482.71</p><p>1949-1.8</p><p>19505.79</p><p>19515.87</p><p>19520.88</p><p>19530.62</p><p>1954-0.5</p><p>19550.37</p><p>19562.86</p><p>19573.02</p><p>19581.76</p><p>19591.5</p><p>19601.48</p><p>19610.67</p><p>19621.22</p><p>19631.65</p><p>19641.19</p><p>19651.92</p><p>19663.35</p><p>19673.04</p><p>19684.72</p><p>19696.11</p><p>19705.49</p><p>19713.36</p><p>19723.41</p><p>19738.8</p><p>197412.2</p><p>19757.01</p><p>19764.81</p><p>19776.77</p><p>19789.03</p><p>197913.31</p><p>198012.4</p><p>19818.94</p><p>19823.87</p><p>19833.8</p><p>19843.95</p><p>19853.77</p><p>19861.13</p><p>19874.41</p><p>19884.42</p><p>19894.65</p><p>19906.11</p><p>19913.06</p><p>19922.9</p><p>19932.75</p><p>19942.67</p><p>19952.54</p><p>19963.32</p><p>19971.7</p><p>19981.61</p><p>19992.68</p><p>20003.39</p><p>20011.55</p><p>20022.38</p><p>20031.9</p><p>Table 6.1</p><p>Period</p><p>01234567</p><p>1Capital Investment10,000(1,949)</p><p>2Accumulated depreciation1,5833,1674,7506,3337,9179,5000.0</p><p>3Year-end book value10,0008,4176,8335,2503,6672,0835000.0</p><p>4Working capital5501,2893,2614,8903,5832,0020.0</p><p>5Total book value (3+4)10,0008,9678,1228,5118,5575,6662,5020.0</p><p>6Sales52312,88732,61048,90135,83419,717</p><p>7Cost of goods sold8377,72919,55229,34521,49211,830</p><p>8Other Costs4,0002,2001,2101,3311,4641,6111,772</p><p>9Depreciation1,5831,5831,5831,5831,5831,583</p><p>10Pretax profit (6-7-8-9)(4,000)(4,097)2,36510,14416,50911,1484,5321,449</p><p>11Tax at 35%(1,400)(1,434)8283,5505,7783,9021,586507</p><p>12Profit after tax (10-11)2,600(2,663)1,5376,59510,7317,2462,946942</p><p>Table 6.2</p><p>Period</p><p>01234567</p><p>1Sales52312,88732,61048,90135,83419,717</p><p>2Cost of goods sold8377,72919,55229,34521,49211,830</p><p>3Other costs4,0002,2001,2101,3311,4641,6111,772</p><p>4Tax on operations(1,400)(1,434)8283,5505,7783,9021,586</p><p>5Cash flow from operations (1-2-3-4)(2,600)(1,080)3,1208,17712,3148,8294,529</p><p>6Change in working capital(550)(739)(1,972)(1,629)1,3071,5812,002</p><p>7Capital investment and disposal(10,000)1,442</p><p>8Net cash flow (5+6+7)(12,600)(1,630)2,3816,20510,68510,1366,1103,444</p><p>9Present value at 20%(12,600)(1,358)1,6543,5915,1534,0742,046961</p><p>Net Present value= +3520 (sum of 9)</p><p>Table 6.4</p><p>Tax Depreciation Schedules by Recovery-Period Class</p><p>Year(s)3-Year5-Year7-Year10-Year15-Year20-Year</p><p>133.332014.291053.75</p><p>244.453224.49189.57.22</p><p>314.8119.217.4914.48.556.68</p><p>47.4111.5212.4911.527.76.18</p><p>511.528.939.226.935.71</p><p>65.768.927.376.235.28</p><p>78.936.555.94.89</p><p>84.456.555.94.52</p><p>96.565.94.46</p><p>106.555.94.46</p><p>113.295.94.46</p><p>125.94.46</p><p>135.914.46</p><p>145.94.46</p><p>155.914.46</p><p>162.994.46</p><p>17-204.46</p><p>212.23</p><p>Table 6.5</p><p>Period</p><p>01234567</p><p>1Sales52312,88732,61048,90135,83419,717</p><p>2Cost of goods sold8377,72919,55229,34521,49211,830</p><p>3Other Costs4,0002,2001,2101,3311,4641,6111,772</p><p>4Tax depreciation2,0003,2001,9201,152576</p><p>5Pretax profit (1-2-3-4)(4,000)(4,514)7489,80716,94011,5795,5391,949</p><p>6Taxes at 35%(1,400)(1,580)2623,4325,9294,0531,939682</p><p>Table 6.6</p><p>Period</p><p>01234567</p><p>1Sales52312,88732,61048,90135,83419,717</p><p>2Cost of goods sold8377,72919,55229,34521,49211,830</p><p>3Other costs4,0002,2001,2101,3311,4641,6111,772</p><p>4Tax(1,400)(1,580)2623,4325,9294,0531,939682</p><p>5Cash flow from operations (1-2-3-4)(2,600)(934)3,6868,29512,1638,6784,176(682)</p><p>6Change in working capital(550)(739)(1,972)(1,629)1,3071,5812,002</p><p>7Capital investment and disposal(10,000)1,949</p><p>8Net cash flow (5+6+7)(12,600)(1,484)2,9476,32310,5349,9855,7573,269</p><p>9Present Value= +3802 (sum of 9)(12,600)(1,237)2,0473,6595,0804,0131,928912</p><p>Net present value= +3802 (sum of 9)</p><p>7.1</p><p>Plotting data Fig 7.1</p><p>EquitiesBondsBills190019011902190319041905190619071908190919101911191219131914191519161917191819191920192119221923192419251926192719281929193019311932193319341935193619371938193919401941194219431944194519461947194819491950195119521953195419551956195719581959196019611962196319641965196619671968196919701971197219731974197519761977197819791980198119821983198419851986198719881989199019911992199319941995199619971998199920002001200220032004</p><p>19001.001.001.00Equities1.001.241.471.551.331.702.082.161.532.242.692.462.602.792.572.433.373.592.913.484.203.453.855.035.186.588.449.2412.3017.0614.5810.465.875.298.348.7012.5316.5810.8413.8914.2913.2611.9513.8617.7821.5829.7828.0229.0129.6435.6746.1755.7563.2463.6195.48119.55129.40116.09168.32190.44192.01244.70219.72265.71308.62353.13322.38414.85473.70421.87422.01496.62585.91477.42341.89473.43599.30583.50637.61800.601,070.161,030.031,222.751,509.691,555.692,062.292,394.212,448.672,888.003,730.543,499.964,697.095,118.315,695.735,692.057,766.729,414.1312,359.9215,255.9718,850.1716,796.6014,953.3411,834.1115,578.51</p><p>19011.241.041.04Bonds1.001.041.071.091.131.151.191.221.231.281.311.351.401.451.491.551.601.651.701.651.661.761.982.052.172.312.442.632.862.862.963.102.943.433.433.773.964.264.274.504.775.065.115.275.385.536.136.125.966.166.566.576.316.386.617.097.006.617.106.676.527.417.498.008.108.388.448.757.957.937.528.439.5510.099.9810.4211.3713.2813.1913.0312.8712.3612.5917.6817.7920.5526.9133.5132.6035.7542.2344.8453.4957.8068.3463.0382.9982.2295.26107.7098.05119.11123.51145.54147.65</p><p>19021.471.071.09Bills1.001.041.091.141.201.251.311.381.471.531.591.671.731.811.912.012.082.142.242.372.502.702.883.023.183.313.443.553.663.793.984.074.114.154.174.174.184.194.204.204.204.204.204.214.234.244.264.274.294.334.384.434.504.574.654.694.774.885.045.125.275.415.525.675.856.066.296.596.877.237.708.218.578.909.5110.2710.8711.4212.0112.8714.2015.8018.1220.0421.8023.9525.7927.3828.8830.7133.2935.8937.8939.2240.3641.9344.2846.5949.0451.4253.8257.0059.1860.1560.77</p><p>19031.551.091.14</p><p>19041.331.131.20</p><p>19051.701.151.25</p><p>19062.081.191.31</p><p>19072.161.221.38</p><p>19081.531.231.47</p><p>19092.241.281.53</p><p>19102.691.311.59</p><p>19112.461.351.67</p><p>19122.601.401.73</p><p>19132.791.451.81</p><p>19142.571.491.91</p><p>19152.431.552.01</p><p>19163.371.602.08</p><p>19173.591.652.14</p><p>19182.911.702.24</p><p>19193.481.652.37</p><p>19204.201.662.50</p><p>19213.451.762.70</p><p>19223.851.982.88</p><p>19235.032.053.02</p><p>19245.182.173.18</p><p>19256.582.313.31</p><p>19268.442.443.44</p><p>19279.242.633.55</p><p>192812.302.863.66</p><p>192917.062.863.79</p><p>193014.582.963.98</p><p>193110.463.104.07</p><p>19325.872.944.11</p><p>19335.293.434.15</p><p>19348.343.434.17</p><p>19358.703.774.17</p><p>193612.533.964.18</p><p>193716.584.264.19</p><p>193810.844.274.20</p><p>193913.894.504.20</p><p>194014.294.774.20</p><p>194113.265.064.20</p><p>194211.955.114.20</p><p>194313.865.274.21</p><p>194417.785.384.23</p><p>194521.585.534.24</p><p>194629.786.134.26</p><p>194728.026.124.27</p><p>194829.015.964.29</p><p>194929.646.164.33</p><p>195035.676.564.38</p><p>195146.176.574.43</p><p>195255.756.314.50</p><p>195363.246.384.57</p><p>195463.616.614.65</p><p>195595.487.094.69</p><p>1956119.557.004.77</p><p>1957129.406.614.88</p><p>1958116.097.105.04</p><p>1959168.326.675.12</p><p>1960190.446.525.27</p><p>1961192.017.415.41</p><p>1962244.707.495.52</p><p>1963219.728.005.67</p><p>1964265.718.105.85</p><p>1965308.628.386.06</p><p>1966353.138.446.29</p><p>1967322.388.756.5...</p></li></ul>