Proposition 2

Proposition 2 is a fundamental theory in the field of corporate finance that relates to the concept of capital structure. It
aims to explain the impact that a company's decision to take on debt has on its cost of capital and asset valuation. The
proposition highlights that the rate of return on equity is directly proportional to the debt ratio of firms, such that a
higher debt ratio means higher financial risks, which subsequently increases the cost of equity.

The concept of capital structure refers to the way in which a company finances its activities through a mix of debt and
equity. The choice between debt and equity, and the proportion of each, implications for the company's efficiency, cost
of funding and financial risk. In addition, the choice of capital structure can determine the value of the firm and the
investors' preferences. According to Proposition 2, the introduction of cheaper financing in the form of debt can help to
reduce the overall cost of capital, as the cost of debt is less than the cost of equity.

However, the cost of equity rises with increased leverage (financial risk) to offset the lower cost of debt.
The cost of equity represents the rate of return required by a company's investors to compensate them for the perceived
level of risk associated with an investment in the company's shares relative to other investment options that would offer
the same level of risk.
The cost of equity can be calculated using the Capital Asset Pricing Model (CAPM) where:
Cost of equity = Risk-free rate + β (return of market - risk-free rate)
The cost of equity, therefore, depends on the market return, the risk-free rate of return, and the company's Beta, which is
the measure of a company's risk relative to the market. Companies with high Beta indicate that they are more risky than
the market, and investors require higher returns to invest in such firms.
The cost of debt, on the other hand, is the interest rate payable on borrowed funds by a company and does not depend
on market conditions. Since debt is considered to be a less risky investment than equity and debt investors have a prior
claim on the company's assets in case of liquidation, their required rate of return is generally lower.

However, as the level of debt is increased, the risk of the firm also increases. This leads to an increase in the cost of
equity as investors require a higher rate of return to compensate for the additional risk.
The interaction between the cost of equity and debt leads to the concept of the optimal capital structure, which is the
level of debt that maximizes the value of the firm. The optimal capital structure strives to balance the advantages and
disadvantages of the various financing options available to the firm. The balance involves weighing lower costs of debt
financing against higher costs of equity financing and increased financial risk.
The WACC (weighted average cost of capital) can be used to evaluate the optimal capital structure of a company. The
WACC is a weighted average of the cost of debt and equity, computed based on the proportion of each form of
financing and the costs relevant to it. It can be expressed as follows:
WACC = (E/V) x Re + (D/V) x Rd x (1 - T)
Where
Re : Cost of equity
Rd : Cost of debt
T : Corporate Tax rate
E : Market Value of equity
D : Market Value of debt
V : Total Market value of equity and debt

The optimal capital structure is the one that maximizes the firm's value by minimizing the WACC. According to
Proposition 2 if a company decides to increase its leverage through debt financing so that the debt ratio rises. The higher
leverage leads to an increased financial risk that raises the cost of equity. The total cost of capital is composed of the
weighted average of the cost of equity and debt and, therefore, increases with the higher cost of equity.
Proposition 2 asserts that firms should aim to achieve the optimal capital structure that balances the debt and equity
financing but accommodates all the relevant factors such as the market, taxations, and regulations. Moreover, if the
assumptions of low taxes and no bankruptcy costs hold, then the increase in financial leverage will not impact the value
of the firm, and the market value will remain unchanged. The proposition is a fundamental theory in the field of
corporate finance, which guides businesses in creating an optimal capital structure that maximizes their value and
reduces the cost of capital.

SCRIPT 2

Proposition 2 is a key concept in Capital Structure Theory and it explains the relationship between financial leverage and
the cost of capital. According to this proposition, the rate of return on equity grows linearly with the debt ratio. In other
words, as a company takes on more debt, the cost of equity must rise in proportion, which offsets the lower cost of debt.

To understand this concept better, we need to consider the factors that affect the cost of equity and debt financing. The
cost of equity reflects the return that investors require to compensate for the risk of investing in the company. As a
company increases its debt financing, it is perceived as taking on more financial risk, which increases the risk of default
and bankruptcy. This increased risk is reflected in the higher cost of equity, as investors demand a higher return to
compensate for the added risk.

On the other hand, the cost of debt reflects the interest rate that a company must pay on its borrowed funds. Debt
financing is generally cheaper than equity financing, as debt holders have a lower level of risk than equity holders.
However, as a company takes on more debt, it becomes more leveraged and more vulnerable to fluctuations in interest
rates. This increased risk is reflected in the higher interest rate that a company must pay on its debt.

The graph here on slide 2 depicts the relationship between the debt ratio and the WACC. It shows that as the debt ratio
of the company increases, the WACC decreases due to the lower cost of debt financing. However, as the debt ratio
continues to increase, the cost of equity financing eventually increases as well, offsetting the benefits of lower debt costs.
This results in a constant WACC and constant level of firm value.

In summary, Proposition 2 suggests that there is an optimal capital structure for a company, where the benefits of debt
financing (the lower cost of funding) are offset by the increased risk of financial distress. As a company moves away from
this optimal capital structure (e.g. by taking on too much debt), the cost of equity rises in proportion to the debt ratio,
which reduces the benefit of the lower cost of debt. This means that the overall cost of capital does not change
significantly, and the value of the company remains constant.

It is important to note that Proposition 2 assumes there are no taxes, bankruptcy costs, or other market imperfections
that would affect the relationship between leverage and cost of capital. However, in the real world, these factors can have
a significant impact on a company's capital structure decisions.
SCRIPT

[Slide 1: Introduction]
Title: Understanding Proposition 2 in Capital Structure Theory
Hello everyone,
Today, we'll delve into a fundamental concept in Capital Structure Theory known as Proposition 2. This
proposition sheds light on the intricate relationship between financial leverage and the cost of capital within
a company.
[Slide 2: Explanation of Proposition 2]
Title: Proposition 2: Debt Ratio vs. Cost of Capital
Proposition 2 posits that the rate of return on equity increases linearly with the debt ratio. In simpler terms,
as a company takes on more debt, the cost of equity rises proportionally, countering the lower cost of debt.
[Slide 3: Factors Influencing Cost of Equity and Debt Financing]
Title: Factors Affecting Cost of Financing
To grasp Proposition 2 fully, let's dissect the factors influencing the cost of equity and debt financing. The
cost of equity reflects the return demanded by investors to offset the risk of investing in the company. As a
company assumes more debt, it amplifies its financial risk, leading to higher perceived risk of default and
bankruptcy. Consequently, investors demand higher returns, driving up the cost of equity.
Conversely, the cost of debt represents the interest rate a company pays on borrowed funds. Debt financing
typically incurs lower costs compared to equity financing due to lower risk for debt holders. However, as a
company increases its debt load, it becomes more sensitive to interest rate fluctuations, elevating the risk.
This increased risk translates to higher interest rates on debt.
[Slide 4: Graph Illustrating Debt Ratio vs. Weighted Average Cost of Capital (WACC)]
Title: Relationship Illustrated
This graph portrays the correlation between the debt ratio and the Weighted Average Cost of Capital
(WACC). As the debt ratio climbs, the WACC initially decreases due to cheaper debt financing. However, as
the debt ratio surges further, the cost of equity rises, offsetting the benefits of lower debt costs.
Consequently, we witness a stabilization in WACC and firm value.
[Slide 5: Conclusion]
Title: Optimizing Capital Structure
In summary, Proposition 2 suggests an optimal capital structure for companies, where the advantages of debt
financing are balanced against the increased risk of financial distress. Straying from this optimal structure,
such as overleveraging, leads to a proportional rise in the cost of equity, diminishing the benefits of cheaper
debt. Thus, the overall cost of capital remains relatively constant, maintaining the company's value.
It's worth noting that Proposition 2 operates under ideal conditions, without considering taxes, bankruptcy
costs, or market imperfections. In reality, these factors can significantly influence a company's capital
structure decisions.
[Slide 6: Q&A]
Title: Questions & Discussion
Now, I welcome any questions or discussions you may have regarding Proposition 2 and its implications in
capital structure management.
Thank you.