Risk, cost of capital, capital structures

inefficient portfolio

a portfolio for which we can find another portfolio that has a higher expected return but the same volatility

CAPM (perfect market) assumptions

1. investors buy and sell at competitive prices, without transaction costs or taxes, and can lend and borrow at the risk free rate

2. investors have homogenous beliefs and expectations → everyone has the same publicly available data

3. investors only hold efficient portfolios

SML

tell us the reward for bearing risk

higher beta → higher systematic risk → higher expected return

unlevered equity

equity in a firm with no debt

levered equity

equity in a firm with debt

MM perfect market conditions

1. securities trade at a competitive price equal to the PV of their cash flows

2. No taxes, transaction costs, or issuance costs

3. Financing choices do not change the firms investment cash flows and reveal no new information

MM I

E + D = U = A

The total value of a firms securities is equal to the market value of the cash flows generated by its assets regardless of the capital structure

MM II

the equity cost of capital rises with the market value debt to equity ratio

MM I + MM II

leverage (and capital structure) does not affect the required return for a company, only how it is split between debt and equity

Rwacc = rU = rA

MM assumptions with corporate taxes

1. corporations are taxed at tau c on earnings after interest

2. there are no transaction or bankruptcy costs

3. individuals and firms can borrow at the same rate