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CHAPTER ONE: MM Theory and No Arbitrage

2. Assets = Liabilities Equity. Accounting Equality: duel entity systemBook value measurement. . . Fund use. Fund source. Finance Equality: Fund use = Fund sourceMarket value measurement. 3. . . . Corporate Finance Assets Liabilities and Equity Asset 1

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CHAPTER ONE: MM Theory and No Arbitrage

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    1. 1 CHAPTER ONE: MM Theory and No Arbitrage MM Theory

    2. 2 Assets = Liabilities + Equity Accounting Equality: duel entity system Book value measurement

    3. 3 Corporate Finance Assets Liabilities and Equity Asset 1 Asset 2 Liabilities Asset 3 . . Equity . Asset n Total Assets Total Liabilities and Equity

    4. 4 Capital Structure Financial leverage:

    5. 5 M&M Theory M&M assumptions: Frictionless assumptions No income taxes No transaction costs No information asymmetry No cost to resolve interest conflicts among stakeholders All liabilities are risk-free

    6. 6 A mini – case: does capital structure matter? Two companies EBIT Capital structure Firm value

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    8. 8 M&M Proposition 1 Proposition 1: Under M&M Assumption, i.e., in the frictionless environment, the total market value of a firm is independent of its capital structure.

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    10. 10 Comparison of Stocks between A and B

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    13. 13 Implication of M&M Theory Frictionless environment does not exist in the real world. Taxes Transaction costs Information asymmetry Costs resolving conflict of interest Liabilities are risk-bearing

    14. 14 — Tax Shield Company A:

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    23. 23 P=E(mx) In complete market, there is a unique m that is consistent with market observable security prices In incomplete market, there are many m’s that are consistent with the market observable security prices.

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