Capital Structure in a Perfect Market

Overview:

Module 6 begins with the question, “Does a perfect capital market exist? If so, what effects does it have on capital structure?” This module (chapters 14 & 15) applies the Law of One Price to a perfect capital market to decide if capital structure affects a firm’s value. What role then, does capital market imperfections play on a firm’s value?  The exploration begins with a look at how debt reduces taxes for investors and firms.

Readings:

Berk, J. & DeMarzo, P. (2020). Corporate finance: The core (5th ed.). Pearson. ISBN: 9780135183793. Read Chapters 12, 13

Key Terms and Concepts:

Chap 14 & 15

  • capital structure
  • homemade leverage
  • market value balance sheet
  • conservation of value principle
  • interest tax shield
  • perfect capital markets
  • debt-to-value ratio
  • leveraged recapitalization
  • unlevered equity
  • dilution
  • levered equity

 

Goals Alignment:

University Mission Goals – 4

Program Goals – 3

Course Goals – E, F

Conclusion:

This module explored capital structure in the setting of a perfect capital market. Students considered the existence of a perfect capital market and its implications on the value of a firm. The Modigliani-Miller propositions I and II were introduced, and students were asked to discuss their importance and how they relate to the Law of One Price. Students had to think critically about capital structure fallacies and discuss the application of these ideas and how they affect a firm’s value.

The module then analyzed the role of debt in reducing taxes. Students were introduced to interest tax deductions and shields, and consequently, their effects on leverage. Students then applied their knowledge by calculating of tax shields, value of levered firms, the weighted average cost of capital and tax benefits to apply new knowledge of tax. Students were asked to think critically about optimal capital structures with their relationships to personal taxes and EBIT.

In the next module, we continue our exploration of the effect of capital market imperfections on a firm’s value by looking at financial stress, managerial incentives, and payout policies.

Assignment:

Questions:

  1. What type of capital structure should a firm choose and why? In you answer, be sure to include capital structure fallacies and their effects on a firm’s decision.
  2. Define and discuss MM Proposition I with its implications, and the roles of homemade leverage and the Law of One Price in the development of the proposition.
  3. What is leveraged recapitalization and what effects does it have on the value of equity?
  4. Define the optimal fraction of debt and the growth rate of a firm. What is the relationship between the two?

Essays:

  1. Define the three conditions that make up a perfect capital market, and then compare and contrast the effects of perfect capital markets and imperfect capital markets on value. Can they create or destroy value? Explain.
  2. Define EBIT and discuss why the optimal level of leverage from a tax-saving perspective is the level at which interest equals EBIT. Does this have a connection with under-leveraging corporations–both domestically and internationally?