Capital Structure and Firm Value

The return on equity (ROE) is the net income divided by total equity.

Financial leverage refers to the use of debt financing in a company's capital structure. It magnifies the returns to equity holders when the return on assets exceeds the cost of debt. However, it also magnifies the risk to equity holders when the return on assets is less than the cost of debt.

The break-even point in EBIT is the level of earnings before interest and taxes (EBIT) where the earnings per share (EPS) are the same regardless of whether the company uses debt or equity financing.

The Modigliani-Miller theorem, under the assumptions of no taxes, no transaction costs, and perfect capital markets, states that the value of a firm is independent of its capital structure. This means that using debt or equity financing will not affect the overall value of the company.

Earnings per share (EPS) are the net income of a company divided by the number of outstanding shares. It represents the portion of a company's profit that is allocated to each outstanding share.

Return on assets (ROA) is a profitability ratio that measures how efficiently a company uses its assets to generate earnings. It is calculated as net income divided by total assets.

An increase in debt financing will typically increase the return on equity (ROE) in a company. However, it also increases the financial risk associated with the business.

The debt-to-equity ratio is a financial leverage ratio that measures the amount of debt a company uses to finance its assets relative to the amount of equity. A higher ratio indicates a greater reliance on debt financing.

Financial Leverage can be a powerful tool to increase profitability and returns to equity holders. However, it is important to note that it also increases the risk of bankruptcy if the company's earnings fall short of expectations.

EBIT stands for earnings before interest and taxes. It's a measure of a company's operating profitability before considering interest expenses and income taxes.

The proposition states that a company's value is independent of its capital structure, meaning that the mix of debt and equity financing does not affect the firm's overall value.

This means that investors can create the same risk and return profile as a levered firm by using their own leverage. It effectively eliminates the need for a firm to use debt to achieve a specific risk-return profile.

Similar to Homemade Leverage, but applied in reverse. An investor can recreate the risk and return profile of an unlevered firm by investing in both debt and equity of a levered firm.

This assumption states that everyone in the market has the same information and expectations about a firm's future cash flows. In other words, there's no information asymmetry. This enables everyone to price assets correctly.

This assumption implies that firms operating in the same industry share similar risks inherent in the industry. This allows for comparable valuations across firms within a sector.

This assumes that the firm will exist and generate cash flows forever. It simplifies the analysis and avoids dealing with the complexities of a finite life.

These are a set of idealized conditions that are assumed to hold in the Modigliani-Miller model. These conditions are rarely met in the real world, but they help to simplify the analysis and provide a baseline for understanding how financing decisions affect firm value.

These markets are perfectly competitive, meaning that there are many buyers and sellers, and no single participant can influence the price. Other assumptions include: Firms and investors can borrow/lend at the same interest rate, everyone has access to the same information, there are no transaction costs, and no taxes.

The share of your funds that you need to invest in the levered firm's debt, represented by the variable 'x.'

The formula used to determine the share of your funds to allocate towards the levered firm's debt, 'x.' The formula expresses 'x' as a function of itself squared in the numerator and 1 minus 'x' cubed in the denominator.

The process of adjusting your own investment portfolio to mimic the financial leverage of a company you wish to invest in, either by borrowing or lending.

The ratio of debt holdings to equity holdings in a levered firm. It is calculated by dividing the dollar value of debt by the dollar value of equity.

The Modigliani-Miller (MM) Proposition I states that in a perfect market with no taxes, the value of a firm is independent of its capital structure. This means that using debt or equity financing does not affect the overall value of the company.

The two key assumptions underlying the Modigliani-Miller (MM) proposition: 1) Taxes are zero; 2) Individuals can borrow at the same interest rate as firms.

The weighted average cost of capital (WACC) remains constant for a given firm, regardless of its leverage. This means that the cost of capital does not change when a company takes on more debt.

If individuals borrow at a higher rate than corporations, then corporations can increase their value by borrowing. This is because they can borrow at a lower rate than individuals.

The weighted average cost of capital (WACC) represents the average cost of financing a company's operations, considering both debt and equity financing. It is a critical metric for evaluating investment projects, as it reflects the required return investors expect for providing capital.

Proposition I of Modigliani-Miller (MM) theory states that a firm's value is independent of its capital structure. This implies that using debt or equity financing will not affect the overall value of the company, given the assumptions of no taxes, no transaction costs, and perfect capital markets.

Proposition II of MM theory with no taxes states that increasing leverage (debt) increases the risk and expected return to stockholders. This occurs because the risk of financial distress increases as debt levels rise, but the potential for higher returns also increases.

The expected rate of return on a firm's equity (cost of equity), represented by rs, is calculated as r0 + (B/S) (r0 - rB). It represents the return investors demand to compensate for the risk of investing in the company's equity.

The cost of equity is the rate of return that investors require for investing in a levered firm's equity. This cost is affected by several factors, including the company's financial risk (leverage), business risk (risk from the company's operations), market risk (general stock market risk), and the firm's financial structure.

The cost of debt is the rate of return that a firm must pay to its creditors for borrowing funds. It is typically reflected in the interest rate associated with the firm's debt.

The value of a levered firm (with debt) is equal to the value of an unlevered firm (no debt) plus the present value of the tax shield on debt. The tax shield is the value of the tax savings a company enjoys from deducting interest payments on debt from taxable income.

The Modigliani-Miller (MM) Theory with taxes indicates that a firm's value increases as it leverages due to the tax deductibility of interest payments. This means that using debt financing can actually increase a company's value in a world with taxes.

The Modigliani-Miller (MM) Proposition II states that a company's overall cost of capital (rWACC) remains constant regardless of its capital structure when there are no corporate taxes. This means that whether a company uses more debt or equity financing, its cost of capital will not change. This is because the increased risk associated with a higher debt-to-equity ratio is offset by the lower cost of debt. The MM Proposition II is a theoretical concept that assumes perfect capital markets, no transaction costs, and no taxes.

In MM Proposition II (with no taxes), the cost of equity (rS) increases as the debt-to-equity ratio increases because the remaining equity becomes riskier. However, this increase in the cost of equity is perfectly offset by the lower cost of debt. As a result, the weighted average cost of capital (rWACC) remains constant.

The Modigliani-Miller (MM) Proposition II is a theoretical concept used to understand the relationship between a company's capital structure and its cost of capital. It states that a company's value is independent of its capital structure in a perfect market with no taxes. In simpler terms, it suggests that how a company finances itself (debt or equity) doesn't change its overall value.

In the real world, companies don't always follow the MM Proposition II because of factors like taxes, transaction costs, and market imperfections. Despite these complexities, the MM Proposition II is a fundamental concept that helps to understand the relationship between capital structure and firm value.

This theory implies that a company's value is independent of its capital structure. However, in the real world, capital structure does influence value, and the MM model is a simplification. It doesn't account for taxes, bankruptcy costs, or other complexities that exist in real-world financial markets. Nonetheless, it provides a theoretical framework helpful for understanding the relationship between capital structure and firm value.

The value of a levered firm (with debt) is equal to the value of an unlevered firm (no debt) plus the present value of the tax shield on debt. This tax shield is the benefit of deducting interest payments on debt from taxable income.

The cost of equity (rS) increases as the debt-to-equity ratio increases because the remaining equity becomes riskier. However, this increase is perfectly offset by the lower cost of debt. As a result, the weighted average cost of capital (rWACC) remains constant.

The weighted average cost of capital (WACC) remains constant, regardless of leverage. This implies that the cost of capital doesn't change when a firm takes on more debt.

The formula for calculating the expected rate of return on a firm's equity (cost of equity) is: rS = r0 + (B/S)(r0 - rB). It represents the return investors demand to compensate for the risk of investing in the company's equity.

Financial leverage is the use of debt financing in a company's capital structure. It can amplify returns to equity holders when the return on assets exceeds the cost of debt. However, it also magnifies the risk to equity holders if the return on assets is less than the cost of debt.

The Modigliani-Miller Theorem (MM Theorem) states that a firm's value is independent of its capital structure in a perfect market with no taxes. This means that using debt or equity financing does not affect the overall value of a company under these ideal conditions.

The value of a levered firm increases with leverage, as described by the formula: VL = VU + TC rB B. This equation highlights the benefit of the interest tax shield, which is the tax savings a company enjoys from deducting interest payments on debt from taxable income.