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6. Corporate Capital Structure Notes

Finance Notes > Corporate Finance Notes

This is an extract of our 6. Corporate Capital Structure document, which we sell as part of our Corporate Finance Notes collection written by the top tier of University Of London (examined By LSE) students.

The following is a more accessble plain text extract of the PDF sample above, taken from our Corporate Finance Notes. Due to the challenges of extracting text from PDFs, it will have odd formatting:

Corporate Capital Structure
Choices of Corporate Capital Structure
Corporate Capital Structure
Features of Corporate Debt
 Bond-holders have priority over equity-holders in times of corporate bankruptcy
 Interest paid to debt claims is deductible from corporate tax
Debt-Holders

Equity-Holders

Payoff

Payoff

B

XT

BB
XT < B, Payoff = XT

XT < B, Payoff = 0

XT = B, Payoff = B

XT = B, Payoff = 0

XT > B, Payoff = B

XT > B, Payoff = XT - B

 Payoff = min (XT, B)

 Payoff = max (XT - B, 0)

Payoff of Equity-financed and Debt-financed
Unlevered Firm (U) = entirely equity-financed
Levered Firm (L) = both equity-financed and debt(bond)-financed
Bond issued by L = B
Debt Interest Rate = RB
Cash flow of firm at Time 1 = X1
Case 1: Payoff for investors buying 100% equity of U
X1 < B(1 + RB)

X1 > B(1 + RB)

Debt

0 0

Equity

X1

X1

Total

X1

X1

1 Case 2: Payoff for investors buying 100% equity and debt of L
X1 < B(1 + RB)

X1 > B(1 + RB)

Debt

X1

B(1 + RB)

Equity

0 [X1 - B(1 + RB)]

Total

X1

X1

Modigliani-Miller Theorem (MM1)
 Same payoff to investor in the future
 Same cost at present
 Same value for both firms
 Modigliani-Miller Theorem: firm value does not depend on the capital structure measured by the debt-equity ratio (D/E)
Assumptions:
 Capital markets have no frictions:
o No taxes

No transactions costs

Costless bankruptcy
 Investors have perfect information (CH7)
 Investors have homogeneous expectations
 Investors care only about their wealth
 Financing decisions do not affect investment outcomes
CTU = Amount Paid Out by U at T
CTL = Amount Paid Out by L at T
C = Corporate Tax Rate
Case 1: Corporate Tax
Unlevered Firm (U)
Corporate Tax = CXT
CTU = XT - CXT
CTU = XT(1 - C)
Levered Firm (L): Assume XT > BRB
Bond Interest for Debt Holders = BRB

2

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