MM 1 – LEVERAGE, ARBITRAGE, AND FIRM VALUE
In this perfect capital markets, leverage would not afect the total value of
the firm (i.e. the amount of mone the entrepreneur can raise).
o Leverage onl changes the allocaton of CFs between debt and equit ,
without altering the total CF of the firm.
o Perfect capital markets:
Investors and firms can trade the same set of securites at
compettve market prices equal to the P o of their future CFs.
There are no taxes, transacton costs or issuance costs
associated with securit trading.
A firm’s financing decisions don’t change the CFs generated b
its investments, nor do the reveal new informaton about
them.
So, under MM 1, the role of capital structure in determining firm value: In a
perfect capital market, the total value of a frm ii equal to the market value
of the total CFi generated by iti aiieti and ii not afected by iti choice of
capital itructure.
o So the total value of the firm is that of the cash fows generated b its
operating assetss.
Or the tsotsal cash foo paid tso all of a frm’s securitsy; holders is
equal tso tshe tsotsal CF generatsed by; tshe frm’s assetss.
o Thus, b the law of one price, tshe frm’s securities and assetss musts
have tshe same markets value.
o Thus, as long as the firm’s choice of securites does not change the CFs
generated b its assets, this decision will not change the total value of
the firm or the amount of capital it can raise.
o And, if securites are fairl priced, then bu ing or selling securites has
an NP o of zero, and thus, should not change the value of the firm.
o The future repa ment that the firm must make on its debt is equal in
value to the amount of the loan it receives upfront.
In this perfect capital markets, leverage would not afect the total value of
the firm (i.e. the amount of mone the entrepreneur can raise).
o Leverage onl changes the allocaton of CFs between debt and equit ,
without altering the total CF of the firm.
o Perfect capital markets:
Investors and firms can trade the same set of securites at
compettve market prices equal to the P o of their future CFs.
There are no taxes, transacton costs or issuance costs
associated with securit trading.
A firm’s financing decisions don’t change the CFs generated b
its investments, nor do the reveal new informaton about
them.
So, under MM 1, the role of capital structure in determining firm value: In a
perfect capital market, the total value of a frm ii equal to the market value
of the total CFi generated by iti aiieti and ii not afected by iti choice of
capital itructure.
o So the total value of the firm is that of the cash fows generated b its
operating assetss.
Or the tsotsal cash foo paid tso all of a frm’s securitsy; holders is
equal tso tshe tsotsal CF generatsed by; tshe frm’s assetss.
o Thus, b the law of one price, tshe frm’s securities and assetss musts
have tshe same markets value.
o Thus, as long as the firm’s choice of securites does not change the CFs
generated b its assets, this decision will not change the total value of
the firm or the amount of capital it can raise.
o And, if securites are fairl priced, then bu ing or selling securites has
an NP o of zero, and thus, should not change the value of the firm.
o The future repa ment that the firm must make on its debt is equal in
value to the amount of the loan it receives upfront.
