Chapter 14
Capital Structure in a Perfect Market
I. Chapter Outline
The following chapter outline is correlated to the PowerPoint Lecture Slides. The PowerPoint slides
are referenced in bold. Alternative Examples to selected textbook examples are also available in the
PowerPoint Lecture Slides and are also referenced in bold.
14.1 Equity Versus Debt Financing (Slide 7)
• Financing a Firm with Equity (Slides 8–15)
• Table 14.1 The Project Cash Flows (Slide 9)
14.2 Modigliani-Miller I: Leverage, Arbitrage, and Firm Value (Slides 36–38)
• MM and the Law of One Price (Slide 39)
• Homemade Leverage (Slides 40–46)
• Table 14.6 Replicating Levered Equity Using Homemade Leverage (Slide 42)
14.3 Modigliani-Miller II: Leverage, Risk, and the Cost of Capital (Slide 68)
• Leverage and the Equity Cost of Capital (Slides 69–76)
• Example 14.4 Computing the Equity Cost of Capital (Slides 77–78)
• PowerPoint Alternative Example 14.4 (Slides 79–80)
Berk/DeMarzo • Corporate Finance, Fourth Edition 61
• Capital Budgeting and the Weighted Average Cost of Capital (Slides 81–85)
• Figure 14.1 WACC and Leverage with Perfect Capital Markets (Slide 84)
• Example 14.5 Reducing Leverage and the Cost of Capital (Slides 86–87)
• PowerPoint Alternative Example 14.5 (Slides 88–91)
• Common Mistake: Is Debt Better Than Equity?
14.4 Capital Structure Fallacies (Slides 102–107)
• Leverage and Earnings per Share (Slides 102–106)
14.5 MM: Beyond the Propositions (Slide 116)
II. Learning Objectives
14-1 Define the types of securities usually used by firms to raise capital; define leverage.
14-3 List the three conditions that make capital markets perfect.
14-5 Calculate the cost of capital for levered equity according to MM Proposition II.
14-7 Calculate the market risk of a firm’s assets using its unlevered beta.
14-9 Compute a firm’s net debt.
14-11 Show the effect of dilution on equity value.
14-12 Explain why perfect capital markets neither create nor destroy value.
III. Chapter Overview
In this chapter, the capital structure decision is examined in a setting of perfect capital markets in
which all securities are fairly priced, there are no taxes or transactions costs, and the total cash flows
of the firm’s projects are not affected by how the firm finances them.
14.1 Equity Versus Debt Financing
Table 14.1 presents a risky project that can be financed completely with equity or with a portion of
debt and the remainder in equity. Table 14.2 shows the return under each scenario, that shareholders
14.2 Modigliani-Miller I: Leverage, Arbitrage, and Firm Value
This section shows how MM relates to the Law of One Price. Table 14.6 shows how individuals can
14.3 Modigliani-Miller II: Leverage, Risk, and the Cost of Capital
This section begins with Proposition I and shows Proposition II. That is, the cost of capital of levered
equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the
14.4 Capital Structure Fallacies
This section examines two incorrect arguments that are sometimes cited in favor of leverage:
14.5 MM: Beyond the Propositions
The MM propositions were important in the field, not just for their findings, but for the way in which
they taught finance researchers to reason. Proposition I was one of the first arguments to use the Law
IV. Spreadsheet Solutions in Excel
The following Problems for Chapter 14 have spreadsheet versions of the problems available: 5, 9, and
21.
These spreadsheets can be downloaded from the Instructor’s Resource Center at: