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Unit 1 Fin 31 - Coggle Diagram
Unit 1 Fin 31
The Effect of Financial Leverage
Capital structure- When choosing debt to equity always choose what maximezes the value of a share of stock.
Value of firm maximized when WACC is maximized, Because values and discount rates move in opposite
directions, minimizing the WACC will maximize the value of the firm’s cash flows.
Homemade leverage- Use of personal borrowing to change the overall amount of financial leverage which the individual is exposed to.
Assumptions
Individual + corporation lend at same interest rate
No taxes
M&M Proposition 1- The value of the firm is independent of the firms capital structure.
M&M Proposition 2- A firm's cost of equity capital is a positive linear function of the firm's capital structure.
Business and Financial Risk
Business risk- Risk that co0mes from the nature of the firm's operating activities
Financial risk- Risk that comes from the financial policy (capital structure) of the firm.
Bankruptcy costs
When firm unable to pay bondholders, firm's assets ultimately transfer to them.
Firm bankrupt when value of assets equals value of debt
Direct bankruptcy costs- Costs that are directly associated with bankruptcy (legal + administrative)
Indirect bankruptcy costs- Costs of avoiding a bankruptcy filing by a financially distressed firm
Financial distress costs- Direct + indirect costs associated with going bankrupt or experiencing financial distress
Static theory of capital structure- The theory that a firm borrows up to where the tax benefit from the extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress.
Marketed vs nonmarketed claims
Marketed claims- Can be bought and sold in financial markets
Nonmarketed- Cannot be sold in financial markets
Revision of Cost of Capital
The cost of capital depends primarily on the use of the funds, not the source.
Securities Market Line (SML)
Dividend Growth Model (DGM)