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120203033
120203034 Ripon Das
TOPIC
Outline
Meaning of Capital Structure Leverage and Capital Structure ModiglianiMiller theory
> Without Tax > With Tax
Capital Structure
The combination of a company's long-term debt, specific short-term debt, common equity, and preferred equity; the capital structure is the firm's various sources of funds used to finance its overall operations and growth. Debt comes in the form of bond issues or long-term notes payable, whereas equity is classified as common stock, preferred stock, or retained earnings. Short-term debt such as working capital requirements also is considered part of the capital structure
Capital structure decision involves a trade off between risk and return to maximize market price per share
Proposition I:
levered firm value = unlevered firm value. VL = VU = (EBIT/WACC) = EBIT/ksU
where: ksU = cost of equity for an unlevered firm.
Proposition II:
ksL = ksU + Risk premium = ksU +(ksU - kd)(D/S)
where: ksU = cost of equity for an unlevered firm, ksL= cost of equity for a levered firm, D = market value of firms debt, S = market value of firms equity, kd = cost of risk-free debt. As a firm increases its use of debt, its cost of equity
Proposition I:
VL = VU + TD
where: T = firms tax rate, D = value of debt.
Proposition II:
ksL = ksU + (ksU - kd)(1-T)(D/S)
where: S = value of equity.
Thank You