This document discusses Modigliani and Miller's propositions regarding capital structure. It summarizes:
1) MM's Proposition I states that the market value of a firm is independent of its capital structure in perfect capital markets.
2) Proposition II states that the expected return on equity increases with leverage, but this is offset by a higher risk so shareholders are indifferent to leverage.
3) The weighted average cost of capital remains unchanged with leverage according to MM's theory, contradicting the traditional view that firms should minimize their WACC through leverage.
Working Capital ManagementChapter 15Working Ca.docxdunnramage
Working Capital Management
Chapter 15
Working Capital Terminology
Working capital: current assets.
Net working capital:
current assets - current liabilities.
Net operating working capital:
current assets - (current liabilities - notes payable).
Working capital management:
controlling cash, inventories, and A/R, plus short-term liability management.
2
Working Capital Financing Policies
Aggressive: Use short-term financing to finance permanent assets.
Moderate: Match the maturity of the assets with the maturity of the financing.
Maturity Matching, or “Self-Liquidating”, approach
Conservative: Use permanent capital for permanent assets and temporary assets.
3
Cash Conversion Cycle
The cash conversion cycle focuses on the length of time between when a company makes payments to its creditors and when a company receives payments from its customers.
4
Cash Conversion Cycle
15-5
5
Cash Budget
Forecasts cash inflows, outflows, and ending cash balances.
Used to plan loans needed or funds available to invest.
Can be daily, weekly, or monthly, forecasts.
Monthly for annual planning and daily for actual cash management.
6
Cash and Marketable Securities
Currency
Demand Deposit
Marketable Securities
Inventories
Supplies
Raw materials
Work in process
Finished goods
Accounts Receivable: Credit Policy
Credit Period: How long to pay? Shorter period reduces days sales outstanding (DSO) and average A/R, but it may discourage sales.
Cash Discounts: Lowers price. Attracts new customers and reduces DSO.
Credit Standards: Restrictive standards tend to reduce sales, but reduce bad debt expense. Fewer bad debts reduce DSO.
Collection Policy: How tough? Restrictive policy will reduce DSO but may damage customer relationships.
9
Accounts Payable: Trade Credit
Trade credit is credit furnished by a firm’s suppliers.
Trade credit is often the largest source of short-term credit, especially for small firms.
Spontaneous, easy to get, but cost can be high.
10
period
deferral
Payables
period
collection
Average
period
conversion
Inventory
CCC
-
+
=
Capital Structure Policy
Chapter 13
Learning Objectives
Understand the difference between business risk and financial risk.
Use the technique of break-even analysis.
Understand capital structure theories.
Business Risk
Business Risk is the variation in the firm’s expected earnings attributable to the industry in which the firm operates.
Determinants of business risk:
The stability of the domestic economy
The exposure to, and stability of, foreign economies
Sensitivity to the business cycle
Competitive pressures in the firm’s industry
Operating Risk
Operating risk is the variation in the firm’s operating earnings that results from firm’s cost structure (mix of fixed and variable operating costs).
Earnings of firms with higher proportion of fixed operating costs are more vulnerable to change in revenues.
5
Operating Lev.
1. Read the information on the STREAMING VIDEO INDUSTRY and apply .docxjeremylockett77
1. Read the information on the STREAMING VIDEO INDUSTRY and apply the elements of PESTEL analysis, PORTER analysis, and STRATEGIC GROUPS analysis.
a. What are the strategically relevant components of the streaming video industry macro-environment? What is the impact of these macro factors on the growth and competitiveness of the industry.
b. Work through each of the vertical and horizontal forces in the Porter model and draw conclusions about rivalry and industry competition. Which of the five competitive forces is strongest? Which is weakest? What competitive forces seem to have the greatest effect on industry attractiveness and the potential profitability of new entrants?
2. Read the information on the impact of the coronavirus and apply the elements of macro environmental and industry level analysis to understand how it impacts the industry forces (PORTER model) for two industries. Go through the forces model, then draw conclusion about whether this will increase or decrease competitiveness and attractiveness in this industry
3. Read the information on Tesla (attached documents). In one reading, Tesla is called either a disrupter or a sustaining innovator. This article also suggests that Tesla maybe a Blue Ocean or a Red Ocean (more traditional strategy) company. How do you interpret Tesla’s strategy? Use information from the articles, the most recent earnings presentation, and your evaluation of company financial performance in supporting your answer.
Red Ocean StrategyBlue Ocean Strategy
Compete in existing market space
Create uncontested market space.
Beat the competition
Make the competition irrelevant
Exploit existing demand
Create and capture new demand
Make the value-cost trade-off
Break the value-cost trade-off
Align the whole system of a firms activities with its strategic choice of differentiation or low cost
Align the whole system of a firms activities in pursuit of differentiation and low cost
Working Capital Management
Chapter 15
Working Capital Terminology
Working capital: current assets.
Net working capital:
current assets - current liabilities.
Net operating working capital:
current assets - (current liabilities - notes payable).
Working capital management:
controlling cash, inventories, and A/R, plus short-term liability management.
2
Working Capital Financing Policies
Aggressive: Use short-term financing to finance permanent assets.
Moderate: Match the maturity of the assets with the maturity of the financing.
Maturity Matching, or “Self-Liquidating”, approach
Conservative: Use permanent capital for permanent assets and temporary assets.
3
Cash Conversion Cycle
The cash conversion cycle focuses on the length of time between when a company makes payments to its creditors and when a company receives payments from its customers.
4
Cash Conversion Cycle
15-5
5
Cash Budget
Forecasts cash inflows, outflows, and ending cash balances.
Used to plan loans needed or fun ...
Working Capital ManagementChapter 15Working Ca.docxdunnramage
Working Capital Management
Chapter 15
Working Capital Terminology
Working capital: current assets.
Net working capital:
current assets - current liabilities.
Net operating working capital:
current assets - (current liabilities - notes payable).
Working capital management:
controlling cash, inventories, and A/R, plus short-term liability management.
2
Working Capital Financing Policies
Aggressive: Use short-term financing to finance permanent assets.
Moderate: Match the maturity of the assets with the maturity of the financing.
Maturity Matching, or “Self-Liquidating”, approach
Conservative: Use permanent capital for permanent assets and temporary assets.
3
Cash Conversion Cycle
The cash conversion cycle focuses on the length of time between when a company makes payments to its creditors and when a company receives payments from its customers.
4
Cash Conversion Cycle
15-5
5
Cash Budget
Forecasts cash inflows, outflows, and ending cash balances.
Used to plan loans needed or funds available to invest.
Can be daily, weekly, or monthly, forecasts.
Monthly for annual planning and daily for actual cash management.
6
Cash and Marketable Securities
Currency
Demand Deposit
Marketable Securities
Inventories
Supplies
Raw materials
Work in process
Finished goods
Accounts Receivable: Credit Policy
Credit Period: How long to pay? Shorter period reduces days sales outstanding (DSO) and average A/R, but it may discourage sales.
Cash Discounts: Lowers price. Attracts new customers and reduces DSO.
Credit Standards: Restrictive standards tend to reduce sales, but reduce bad debt expense. Fewer bad debts reduce DSO.
Collection Policy: How tough? Restrictive policy will reduce DSO but may damage customer relationships.
9
Accounts Payable: Trade Credit
Trade credit is credit furnished by a firm’s suppliers.
Trade credit is often the largest source of short-term credit, especially for small firms.
Spontaneous, easy to get, but cost can be high.
10
period
deferral
Payables
period
collection
Average
period
conversion
Inventory
CCC
-
+
=
Capital Structure Policy
Chapter 13
Learning Objectives
Understand the difference between business risk and financial risk.
Use the technique of break-even analysis.
Understand capital structure theories.
Business Risk
Business Risk is the variation in the firm’s expected earnings attributable to the industry in which the firm operates.
Determinants of business risk:
The stability of the domestic economy
The exposure to, and stability of, foreign economies
Sensitivity to the business cycle
Competitive pressures in the firm’s industry
Operating Risk
Operating risk is the variation in the firm’s operating earnings that results from firm’s cost structure (mix of fixed and variable operating costs).
Earnings of firms with higher proportion of fixed operating costs are more vulnerable to change in revenues.
5
Operating Lev.
1. Read the information on the STREAMING VIDEO INDUSTRY and apply .docxjeremylockett77
1. Read the information on the STREAMING VIDEO INDUSTRY and apply the elements of PESTEL analysis, PORTER analysis, and STRATEGIC GROUPS analysis.
a. What are the strategically relevant components of the streaming video industry macro-environment? What is the impact of these macro factors on the growth and competitiveness of the industry.
b. Work through each of the vertical and horizontal forces in the Porter model and draw conclusions about rivalry and industry competition. Which of the five competitive forces is strongest? Which is weakest? What competitive forces seem to have the greatest effect on industry attractiveness and the potential profitability of new entrants?
2. Read the information on the impact of the coronavirus and apply the elements of macro environmental and industry level analysis to understand how it impacts the industry forces (PORTER model) for two industries. Go through the forces model, then draw conclusion about whether this will increase or decrease competitiveness and attractiveness in this industry
3. Read the information on Tesla (attached documents). In one reading, Tesla is called either a disrupter or a sustaining innovator. This article also suggests that Tesla maybe a Blue Ocean or a Red Ocean (more traditional strategy) company. How do you interpret Tesla’s strategy? Use information from the articles, the most recent earnings presentation, and your evaluation of company financial performance in supporting your answer.
Red Ocean StrategyBlue Ocean Strategy
Compete in existing market space
Create uncontested market space.
Beat the competition
Make the competition irrelevant
Exploit existing demand
Create and capture new demand
Make the value-cost trade-off
Break the value-cost trade-off
Align the whole system of a firms activities with its strategic choice of differentiation or low cost
Align the whole system of a firms activities in pursuit of differentiation and low cost
Working Capital Management
Chapter 15
Working Capital Terminology
Working capital: current assets.
Net working capital:
current assets - current liabilities.
Net operating working capital:
current assets - (current liabilities - notes payable).
Working capital management:
controlling cash, inventories, and A/R, plus short-term liability management.
2
Working Capital Financing Policies
Aggressive: Use short-term financing to finance permanent assets.
Moderate: Match the maturity of the assets with the maturity of the financing.
Maturity Matching, or “Self-Liquidating”, approach
Conservative: Use permanent capital for permanent assets and temporary assets.
3
Cash Conversion Cycle
The cash conversion cycle focuses on the length of time between when a company makes payments to its creditors and when a company receives payments from its customers.
4
Cash Conversion Cycle
15-5
5
Cash Budget
Forecasts cash inflows, outflows, and ending cash balances.
Used to plan loans needed or fun ...
All related information about Cost of capital and investment theory for instance, weighted average cost of capital (WACC), cost of debt, cost of equity, investment theories and so on.
Solution Manual for Principles of Corporate Finance 14th Edition by Richard B...ssifa0344
Solution Manual for Principles of Corporate Finance 14th Edition by Richard Brealey, Stewart Myers, Verified Chapters 1 - 34, Complete Newest Version.pdf
Solution Manual for Principles of Corporate Finance 14th Edition by Richard Brealey, Stewart Myers, Verified Chapters 1 - 34, Complete Newest Version.pdf
The white paper presents easiest way to understand the mode of choosing a capital structure of Debt versus Equity.
It also talks on the numerical implications of Leverage and Returns. I hope it will be helpful for students, novices and capital markets professionals !
All related information about Cost of capital and investment theory for instance, weighted average cost of capital (WACC), cost of debt, cost of equity, investment theories and so on.
Solution Manual for Principles of Corporate Finance 14th Edition by Richard B...ssifa0344
Solution Manual for Principles of Corporate Finance 14th Edition by Richard Brealey, Stewart Myers, Verified Chapters 1 - 34, Complete Newest Version.pdf
Solution Manual for Principles of Corporate Finance 14th Edition by Richard Brealey, Stewart Myers, Verified Chapters 1 - 34, Complete Newest Version.pdf
The white paper presents easiest way to understand the mode of choosing a capital structure of Debt versus Equity.
It also talks on the numerical implications of Leverage and Returns. I hope it will be helpful for students, novices and capital markets professionals !
31052024_First India Newspaper Jaipur.pdfFIRST INDIA
Find Latest India News and Breaking News these days from India on Politics, Business, Entertainment, Technology, Sports, Lifestyle and Coronavirus News in India and the world over that you can't miss. For real time update Visit our social media handle. Read First India NewsPaper in your morning replace. Visit First India.
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role of women and girls in various terror groupssadiakorobi2
Women have three distinct types of involvement: direct involvement in terrorist acts; enabling of others to commit such acts; and facilitating the disengagement of others from violent or extremist groups.
01062024_First India Newspaper Jaipur.pdfFIRST INDIA
Find Latest India News and Breaking News these days from India on Politics, Business, Entertainment, Technology, Sports, Lifestyle and Coronavirus News in India and the world over that you can't miss. For real time update Visit our social media handle. Read First India NewsPaper in your morning replace. Visit First India.
CLICK:- https://firstindia.co.in/
#First_India_NewsPaper
03062024_First India Newspaper Jaipur.pdfFIRST INDIA
Find Latest India News and Breaking News these days from India on Politics, Business, Entertainment, Technology, Sports, Lifestyle and Coronavirus News in India and the world over that you can't miss. For real time update Visit our social media handle. Read First India NewsPaper in your morning replace. Visit First India.
CLICK:- https://firstindia.co.in/
#First_India_NewsPaper
हम आग्रह करते हैं कि जो भी सत्ता में आए, वह संविधान का पालन करे, उसकी रक्षा करे और उसे बनाए रखे।" प्रस्ताव में कुल तीन प्रमुख हस्तक्षेप और उनके तंत्र भी प्रस्तुत किए गए। पहला हस्तक्षेप स्वतंत्र मीडिया को प्रोत्साहित करके, वास्तविकता पर आधारित काउंटर नैरेटिव का निर्माण करके और सत्तारूढ़ सरकार द्वारा नियोजित मनोवैज्ञानिक हेरफेर की रणनीति का मुकाबला करके लोगों द्वारा निर्धारित कथा को बनाए रखना और उस पर कार्यकरना था।
‘वोटर्स विल मस्ट प्रीवेल’ (मतदाताओं को जीतना होगा) अभियान द्वारा जारी हेल्पलाइन नंबर, 4 जून को सुबह 7 बजे से दोपहर 12 बजे तक मतगणना प्रक्रिया में कहीं भी किसी भी तरह के उल्लंघन की रिपोर्ट करने के लिए खुला रहेगा।
In a May 9, 2024 paper, Juri Opitz from the University of Zurich, along with Shira Wein and Nathan Schneider form Georgetown University, discussed the importance of linguistic expertise in natural language processing (NLP) in an era dominated by large language models (LLMs).
The authors explained that while machine translation (MT) previously relied heavily on linguists, the landscape has shifted. “Linguistics is no longer front and center in the way we build NLP systems,” they said. With the emergence of LLMs, which can generate fluent text without the need for specialized modules to handle grammar or semantic coherence, the need for linguistic expertise in NLP is being questioned.
2. Capital Structure
A major choice facing a firm is the mix of different
securities (debt and equity) it should choose, to meet
its financing needs.
This mix of different securities is known as the firm’s
Capital Structure.
The choice of capital structure is mainly a marketing
problem for firms because it is subject to the
maximization of its overall market value.
3. Leverage
The firm’s problem is to find that combination of
securities which maximizes its market value.
Before dealing with this marketing problem though,
we need to ensure that a policy which maximizes firm
value also maximizes the shareholders’ wealth.
Let D and E denote the market values of the
outstanding debt and equity of the Wapshot Mining
Company.
4. Each of Wapshot’s 1,000 shares sells for $50
Thus:
E = 1,000 * 50 = $50,000
Wapshot has also borrowed $25,000, and so V, the
aggregate market value of all its outstanding securities,
is
V = D + E = $75,000
5. Wapshot’s stock is known as levered equity.
Q. How does this financial leverage (or gearing) affect
Wapshot’s shareholders?
A. Say Wapshot “levers up” more by borrowing $10,000
more and paying the proceeds to shareholders as a
special dividend of $10 per share.
6. This results in substitution of debt for equity leaving
Wapshot’s assets unchanged.
If V is unchanged at $75,000 then
E = V – D = 75000 – 35000 = $40,000
This implies that the stockholders have suffered a
capital loss (= $50000-40000) which exactly offsets the
$10,000 special dividend.
7. But if V increases to $80000 due to change in the
capital structure, then
E = $45000 and stockholders gain $5000 in all
So in general, increase or decrease in V caused by
change in capital structure accrues to the firm’s
stockholders.
Conclusion: A policy that maximizes market value of
the firm is also best for its shareholders
8. The assumptions that support this conclusion are:
1. Wapshot can ignore dividend policy
2. The old and the new debt is worth $35000 after the
change in capital structure.
9. Modigliani and Miller
If indeed the firm’s aims to find the combination of
securities that maximizes its value, how can this be
achieved?
MM give an answer by saying that in perfect capital
markets, any combination of securities is as good as
another.
Hence, choice of capital structure has no effect on
the firm’s value.
MM’s Proposition I states: “The market value of
any firm is independent of its capital structure.”
10. Example:
Consider 2 firms that differ only in their capital structure.
Firm U is unlevered. Hence, total value of its equity EU is
the same as the total value of the firm.
Firm, L, on the other hand, is levered. The value of its stock
is, therefore, equal to value of the firm less the value of the
debt:
EL = VL – DL
Strategy 1:
Say, you don’t want to take much risk, so you buy common
stock in the unlevered firm U. If you buy 1% of firm U’s
shares, your investment = 0.01 VU and you are entitled to
1% of the gross profits.
11. Strategy 2:
Say, you wanted to buy same fraction of both the debt
and equity of firm L. So, investment in Debt = .01DL
and in Equity = .01 EL
Total investment = 0.01 (DL + EL) = .01 VL
Payoff again is 1% of the firm’s profits.
In perfect markets, both these strategies giving same
payoffs must have same cost.
12. Hence .01VU must = .01VL meaning that Value of
Unlevered firm must equal value of levered firm.
Strategy 3:
You want to take a bit more risk and buy 1% of the
levered firm’s shares.
You invest .01EL = .01 (VL-DL) and expect return = .01
(Profits-Interests)
13. However, an alternative strategy would be to borrow
.01DL on your own account and buy 1% of the stock of
the unlevered firm.
Your investment = .01 (VU-DL) and expected return =
.01(Profits – Interests)
Since, both these strategies offer same payoff again
they must have same cost. So, it must be that .01 (VU-
DL) = .01 (VL-DL)
So, VU must = VL
14. This example shows that if investors can borrow or
lend on their own account and on terms same as the
firm, they can “undo” the effect of any changes in the
firm’s capital structure.
This is the basis for MM’s first proposition, stated
earlier. (see the example from the text)
15. Law of conservation of value
In the context of our discussion on the capital
structure of firms, the law of conservation of value
implies that we can split a cash flow into as many parts
as we like, the values of the parts will always sum back
to the value of the original cash flow stream.
Thus, the value of an asset is preserved regardless of
the nature of the claims against it.
16. Applying the law to the choice between issuing
preferred stock, common stock or a combination of
both, we can say that the choice is irrelevant.
It is contingent on the condition of perfect capital
markets, and that the choice does not affect the firm’s
investment, borrowing and operating policies.
17. Similarly, applying the law to a mix of debt securities
issued by the firm (i.e long-term vs short-term,
secured vs unsecured, senior vs subordinated and
convertible vs nonconvertible), none of the choices
should affect the overall value of the firm. Of course,
the assumption is that both firms and individuals can
borrow/lend at the same risk-free rate.
18. How leverage affects returns
Implications of proposition I for expected returns of a
firm’s stock:
The expected return on Macbeth’s assets rA (in the
example given in the text) is equal to the expected
operating income divided by the total market value of
the firm’s securities:
Expected return on assets = rA = (expected operating
income/market value of all securities)
19. In perfect capital markets the company’s borrowing
decision does not affect either its operating income or
the total market value of its securities.
Hence, its borrowing decision also does not affect the
expected return on the firm’s assets.
20. Expected return on a portfolio consisting of all the
firm’s securities is
Expected return on assets = (proportion in
debt*expected return on debt) +
(proportion in equity*expected return on equity)
rA = {D/(D+E) * rD} + { E/(D+E) * rE}
21. Rearranging terms, we get an expression for the
expected return on equity of a levered firm:
Expected return on equity = expected return on assets
+ [debt-equity ratio *{expected return on assets –
expected return on debt}]
rE = rA + D/E (rA – rD)
22. MM’s Proposition II:
States that the expected rate of return on the common
stock of a levered firm increases in proportion to the
debt-equity ratio (D/E), expressed in market values.
The rate of increase depends on the spread between rA
(expected rate of return on a portfolio of all the firm’s
securities) and rD (expected return on debt)
23. Continuing the Macbeth Spot Removers e.g
Before the firm’s decision to borrow, rE = rA
rE = rA = expected operating income/ market value of
all securities
rE = 1500/ 10000 = .15 = 15%
If the firm decides to borrow, rA is still 15% and rE = rA
+ D/E (rA – rD)
= .15 + (5000/5000)*(.15 - .10)= .20 = 20%
24. For implications of MM’s proposition II refer to the
figure in your texts (or the link of presentation shared)
The figure assumes that the firm’s bonds are
essentially risk-free at low debt levels.
Thus rD is independent of D/E, and rE increases
linearly as D/E increases. As the firm borrows more,
the risk of default increases and the firm is required to
pay higher rates of interest.
Proposition II predicts that when this occurs the rate
of increase in rE slows down. The more debt the firm
has, the less sensitive is to further borrowing.
25. The Risk-Return Trade-off:
Proposition I says that financial leverage has no effect
on shareholders’ wealth.
Proposition II says that the rate of return they can
expect to receive on their shares increases as the firm’s
debt–equity ratio increases.
Despite the 2nd proposition, shareholders are
indifferent to increased leverage.
26. This is so because, any increase in expected return is
exactly offset by an increase in risk and therefore in
shareholders’ required rate of return.
*refer to the example in the text*
As you know, the beta of the firm’s assets equals the
weighted average of the betas of the individual
securities.
27. Beta of assets = (proportion of debt*beta of debt) +
(proportion of equity*beta of equity)
Rearranging,
Beta of equity = beta of assets + debt/equity ratio *
(beta of assets – beta of debt)
Clearly this shows that investors require higher returns
on levered equity to match the increased risk.
28. The traditional position
In response to MM, a traditional position has emerged.
It requires a discussion on Weighted Average Cost of
Capital (WACC), i.e the expected return on a portfolio
of all the company’s securities.
WACC = rA = [ D/V * rD ] + [ E/V * rE ]
The WACC is used in capital budgeting decisions to
find the NPV of projects that would keep business risk
of firms unchanged.
29. If MM’s proposition I holds, then firm’s objective to
“maximize overall market value” is equivalent to
“minimize the wacc”.
If MM’s proposition I doesn’t hold, then the capital
structure that maximizes the value of the firm also
minimizes the weighted-average cost of capital,
provided that operating income is independent of
capital structure.
30. Two Warnings
Warning 1:
Shareholders want management to increase the firm’s value.
They are more interested in being rich than in owning a firm
with a low weighted-average cost of capital.
Warning 2:
Trying to minimize the WACC seems to encourage logical short
circuits like the following. Suppose that someone says,
“Shareholders demand—and deserve—higher expected rates of
return than bondholders do. Hence, debt is the cheaper capital
source. We can reduce the WACC by borrowing more.”
But this doesn’t follow if the extra borrowing leads stockholders
to demand a still higher expected rate of return.
According to MM’s proposition II the cost of equity capital
increases by just enough to keep the WACC constant.