HAWAWINI – CHAP11.
Managers need to make two major decisions: A – What investments to take; B – How to finance it;
A company that decide to finance its projects with external funds, maybe fi nd itself in difficult situation to pay its debts (excessive borrowing). Managers will be under pressure to make decisions that may not be in the best interest of shareholders – example: sell of value –creating assets;
Conversely, a firm with too little debt may pass up the opportunity to reduce its tax payments and increase its value through tax savings.
The firm’s optimal capital structure is the debt ratio that maximizes the market value of the firm’s assets.
We have to analyze how a change in firm’s debt ratio affects:
1 – Profitability, measured with earnings per share (EPS);
2 – Market value of its assets;
3 – Share price;
4 – Cost of capital.
Example: 100% equity finance

Example: Borrow $100M @ 10% and repurchase of 1M shares

EPS increases, but firm’s value remains the same.
MM Theorem – capital structure does not increase firm’s value (in a world without taxes and costs of financial distress). This is explained by risk, any gain in EPS is offset by higher risks company faces by taking debt.
In the example above, shareholders would be better off with leverage, though company’s management might think it is riskier to do it. So shareholder can replicate leverage on his personal account, by borrowing and buying new shares.

* Annual tax shield: Tc x Kd x D

* Vl = Vu + PV ITS

* Pl = Pu + (PV ITS/Nu) A) Pl = share price leveredge B) Pu = share price unleveredge C) Nu = number of shares before recapitalization

* WACC = Ke (E/E+D) + Kd (1-Tc) (D/E+D)

Following MM, when taxes are taking into account, firm’s financing decisions affects the value of its assets, its share price, and its cost of capital. When more and more