M&M Pizza Essay examples

1730 Words Mar 21st, 2016 7 Pages
FINA 351 – Managerial Finance, Chapter 13, Capital Structure, Notes
1. What is Capital Structure (CS)?
It is the mix of debt and equity on the balance sheet. The basic capital structure question is: How much debt is right for this company? Contrary to what your momma may have taught you, according to the so-called finance experts too little debt may be just as costly as too much debt, because debt financing is usually the cheapest source. This is why it is often said that debt is a two-edged sword: too much is bad but so is too little.
2. Why is CS important?
It directly impacts the cost of capital and therefore directly affects the value and profitability of the company. For example, at one time Hershey Foods determined that its
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In other words, if you ignore income tax and financial distress costs, your firm should be worth the same whether it was financed with all debt or all equity. The news camera crew folded up their cameras and said they’d get back to him. Merton decided he had somehow missed his chance to package economic wisdom in 10-second sound-bites.

M&M Theorem and Pizza: After the ball game, the pizza man asked Yogi Berra if the pizza should be cut into four slices as usual, and Yogi replied: “No, cut it into eight; I’m hungry tonight.” The moral of the story? More pieces do not mean more pizza. The main point of the M&M propositions were that if you ignored taxes and financial distress costs, whether you get your L/T financing from debt or equity should not matter.

5. Is there an optimum CS? If so, what about M&M’s Proposition Case I?
As illustrated, Case I shows that the mix of debt/equity doesn’t matter if taxes and financial stress costs are ignored (the size of a pizza doesn’t depend on the number of pieces). But Case
II and Case III show that when taxes and financial distress
(bankruptcy) costs are considered, the value of firm most certainly peaks at an optimum point. Every CFO has a target CS for the optimum level that minimizes cost of capital. An executive at AT&T, for example, was asked by a reporter what its optimum level of debt was. The executive
answered

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