Advanced Corporate Finance

CAPITAL STRUCTURE IN A PERFECTCAPITAL STRUCTURE IN A PERFECTMARKETMARKETJan Schneider

Website

Historical IdeaHistorical Idea

Debt financing is cheaper than equity financing.

Capital Structure is ComplicatedCapital Structure is Complicated

Today's approach: perfect market

No taxesNo transaction costsNo asymmetric informationFinancing decisions do not affect cash flows

Example: Firm L (Levered)Example: Firm L (Levered)

Annual interest payments: $100 in perpetuityAnnual cash flows to equity: $0 or 800 with probability 1/2 inperpetuitybeta of equity: 1risk-free rate: 4%market risk premium: 6%

Example: Firm U (Unlevered)Example: Firm U (Unlevered)

No debtAnnual cash flows to equity: $100 or 900 with probability 1/2 inperpetuity

Cost of CapitalCost of Capital

Weighted average (WACC without tax):

If we solve this equation for :

BetaBeta

Weighted average:

Special case, risk-free debt:

Homemade LeverageHomemade Leverage

Suppose firm U is traded in the market but investors prefer the leveredcapital structure of firm L.

Replicating Unlevered EquityReplicating Unlevered Equity

Suppose firm L is traded in the market but investors prefer theunlevered capital structure of firm U.

Increasing Earnings per Share with DebtIncreasing Earnings per Share with Debt

Suppose firm U currently has 100 shares outstanding.Now the firm decides to adopt the capital structure of L:

1. Raise $2500 debt.2. Use proceeds to repurchase shares.

What is the effect on EPS?

Diluting EPS with new EquityDiluting EPS with new Equity

Suppose firm L currently has 61.54 shares outstanding.Now the firm decides to adopt the capital structure of U:

1. Issue $2500 equity.2. Use proceeds to repay all debt.

What is the effect on EPS?

SummarySummary

If we increase leverage:

Equity beta increases.Equity return increases.Cost of capital remains constant.EPS increases, but price per share remains constant.Investors can privately undo any capital structure choice of the firm.