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Capital Structure, MM Proposition, Leveraged Recapitalization & Optimal Fraction of Debt

1. What type of capital structure should a firm choose and why? In you answer, be sure to include capital structure fallacies and their effects on a firm's decision.
2. Define and discuss MM Proposition I with it's implications, and the roles of homemade leverage and the Law of One Price in the development of the proposition.
3. What is leveraged recapitalization and what effects does it have on the value of equity?
4. Define the optimal fraction of debt and the growth rate of a firm. What is the relationship between the two?

I need original notes that exceed 250 words that will help me answer the questions below:

1. Define the three conditions that make up a perfect capital market, and then compare and contrast the effects of perfect capital markets and imperfect capital markets on value. Can they create or destroy value? Explain.

2. Define EBIT and discuss why the optimal level of leverage from a tax-saving perspective is the level at which interest equals EBIT. Does this have a connection with under-leveraging corporations,both domestically and internationally?

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NOTE: The following discussions are based on my experiences as a finance analyst.

Question 1
The capital structure that a firm should choose is the mix of debt and equity that maximizes shareholders' value, which for publicly listed firms is represented by their market capitalization, through the minimization of the firm's weighted average cost of capital. This capital structure is sometimes called optimal capital structure. What this means is the capital structure chosen by a firm may not necessarily be the optimal capital structure of another firm that operates within the same industry. Given an optimal capital structure, all capital budgeting decisions such as expansions will have to take into account the sources of financing. On the other hand, Nobel Prize-winning economists Franco Modigliani and Merton Miller opine that given specific situations and assumptions, the capital structure of a firm doesn't impact its value.

Question 2
The MM (Modigliani-Miller) Proposition I states that the value, which is represented by market capitalization for publicly listed companies, of a firm is not affected by its capital structure. This means that the value of the firm levered is equal to the value of the firm unlevered. Homemade leverage, which is the use of debt by investors or buyers of the firm's stocks, as it refers to MM posits a scenario wherein the investor can borrow on the exact terms as large firms resulting to the ability to duplicate corporate leverage. The Law of One Price, on the other hand, given a perfect market wherein debt and equity are just different representations of a homogenous good - capital - then arbitrage is possible: ...

Solution Summary

Discusses these corporate finance concepts in 1090 words.