The Equity Premium and the Cost of Capital

1
The Equity Premium and the Cost of Capital

• Arzac, Chapter 3

2
Miller and Modigliani

• MM Proposition I The market value of any firm
  is independent of its capital structure and is
  given by capitalizing its expected return at a
  rate appropriate to its risk class.
• tax shield on debt and changes resulting
• no consider bankruptcy costs

3
Miller and Modigliani

• VL VU tCB where B is the market value of the
  bonds (BkDD/kb)
• so the value of a levered firm is equal to the
  value of an unlevered firm plus the PV of the tax
  shield from debt
• in an MM world with no taxes (tc0), VL VU
  which is prop. I (the method of financing is
  irrelevant)

4
Cost of Equity and Leverage

• return on assets to firm is equal to return on a
  portfolio of its net debt and equity claims
• beta coefficient of firms levered assets
• ßA (D/DE)ßD (E/DE)ßE
• so ßE (1D/E)ßA (D/E)ßD
• ßE (1D/E)ßU (D/E)ßD
• ßE (1D/E)ßU

5
Other Components of Capital Structure

• investment grade debt
• high yield debt
• convertible debt

6
(No Transcript)