How much debt? How much equity?

1. How much debt?How much equity? What is the right mix of issuing stocks and bonds for a firm?

2. Final exam details • Saturday March 16th • IV theater 4:30-6:30 pm • Seats are posted on GauchoSpace under “feedback” in the gradebook • Expect 8 free response questions

3. Capital structure • There are many ways that a firm can raise money • Private investment • Loan money from a bank • Issue stocks and bonds • Issue hybrid securities • Acts like a bond for a number of years with the possibility to convert to a stock later on

4. Firm value • For simplicity, we will assume that a firm’s value only comes from two components • Bonds (debt) • Stocks (equity) • We will define the value of a firm (V)to be equal to the sum of the market values of bonds (B) and stocks (S) • V =B + S

5. What are B and S? • B is the current market value of all debt • Notice that this is different than the face value of all debt • S denotes the current market value of all stocks • As a firm’s value increases, both B and S will typically increase

6. Management decision-making • Should the firm’s management have the goal of maximizing… • …the value of the firm? • …the value of each stock? • …the likelihood that the firm stays in business? • …something else? We compare these two first

7. Comparing the value of a firm with the value of each stock • Stanley’s Sprockets Inc. (SSI) has issued 1,000 shares, valued at $20 each • Total value of the company: $20,000 • SSI is currently unlevered (no debt issued) • SSI management decides to issue bonds: $6,000 • This money will be distributed to the stockholders

8. Comparing the value of a firm with the value of each stock • How much money will each stockholder get once the firm becomes levered? • $6,000 / 1,000 = $6 • Note that this payment takes value from the stock • Without any change in the firm’s value, the $6 payment leads to a decrease of the value of each share of the stock by $6

9. Why might a firm issue debt? • Sometimes, restructuring the amount of a firm’s value that is in stocks and bonds will increase the value of the company • Example: Low interest rates for issuing bonds may increase a firm’s value

10. Without any change in the firm’s value, the $6 payment leads to a decrease of the value of each share of the stock by $6 If the value of a firm increased, then the value of each stock would decrease by less than $6 Notice that even though the value of the stock decreases by less than $6, the stockholder is better off due to the $6 payment Back to a previous point

11. What does this mean? • Changing capital structure either benefits or hurts stockholder value and the firm’s value simultaneously • If one’s value moves in one direction, then the other moves in the same direction • Conclusion: If a firm’s manager maximizes firm value, then the stockholder’s best interests are also looked after

12. Issuing debt and going out of business • If a firm issues bonds, the bondholders get first dibs on getting their money back if the company goes out of business • With an unlevered firm, stock holders will get some amount of money back if there is anything after liquidation • As the firm increases its leverage, stock holders rapidly lose this potential money

13. Example • RU Awake Inc. has been producing a cola product in recent years with twice the caffeine of regular cola • With “energy” drinks entering the market, market share of RU Awake has decreased to the point of not being economically viable to produce cola

14. Example • When the firm goes out of business, assume that the net value of the firm is $100,000 • Value before bondholders (if any) and stockholders are paid • Also assume that each stock sells for $100 (1,000 shares if unlevered)

15. Example • If the firm is unlevered, then the company pays all of its money to stockholders after liquidation • If the firm is levered, then bondholders get what is owed to them before stockholders get anything • For instance, in a highly levered firm, bondholders will get the full $100,000 and the stockholders will get nothing Leverage can thus increase risk of owning the firm’s stock

16. Maximizing the likelihood of staying in business • Firm managers are human • Could the manager care some about job security? • It is up to stockholders to ultimately look out for their own interests through their voting rights

17. How to choose between equity and debt (no taxes) • We start with a world without taxes, bankruptcy, and asymmetric information • We further assume that… • …an individual can borrow at the same rate as a corporation • …there is a single market interest rate • …there is an efficient market

18. M & M • Franco Modigliani and Merton Miller argue that under the assumptions in this simplified world, changing the proportion of capital structure does NOT change firm value • American Economic Review, 1958 • Both Modigliani (1985) and Miller (1990) were awarded the Nobel Prize in Economics

19. M & M Proposition I • Any capital structure is just as good as another for the firm’s stockholders • Another way to state this is that “the value of the levered firm is the same as the value of the unlevered firm” (RWJ p. 494) • This proposition is also known as the capital structure irrelevance principle • What is their argument?

20. M & M argument • Individuals can buy shares and then adjust their leverage, if desired • Since there is a single market interest rate, individuals can also borrow or save to increase or decrease their leverage if they desire

21. Two almost (identical) firms • Suppose that there are two firms that are identical except that one firm is more levered than the other • If one firm had a higher value than the other, then individuals would buy stock of the firm with lower value • The firm values will converge until they hit equilibrium of having the same value

22. Back to our assumptions • Are our assumptions (no taxes, bankruptcy, single interest rate, etc.) correct? • Of course not! • However, we still get some good intuition about how leverage affects the value of a firm • We also can use the simple case to expand to more complicated scenarios • If M & M Proposition I was not a good approximation of the real world, nobody would use it

23. M & M Proposition II • Proposition II deals with how leverage affects return to stockholders • As leverage increases, the stock is riskier • Remember that riskier stocks command a higher expected return (recall ß and the security market line) • Before we move on with M & M II, we need to define weighted average cost of capital

24. Weighted average cost of capital • A firm’s weighted average cost of capital is the weighted average of the costs of debt and equity • Let… • RB be the cost of debt • RS be the expected return on stocks • Also called the cost of equity or required return on equity • RWACC be the firm’s weighted average cost of capital • B be the firm’s total value of bonds • S be the firm’s total value of stocks

25. Weighted average cost of capital • Notice below that the two fractions add up to 1

26. M & M Proposition II • Let R0 be the cost of capital of a firm without debt • This is the shareholder’s return if there are no bonds issued • Only stocks are used to finance the company • In a world with no taxes, RWACC = R0 • We will not derive this: The interested reader can look in-depth in Chapter 16

27. M & M Proposition II To see the algebra, look at footnote 8 on page 497 • Substituting RWACC = R0 into and solving for RS gives us M & M II

28. Interpreting M & M II • How do we interpret ? • If R0 is higher than the cost of issuing bonds (RB), then the firm’s returns on equity increase as the value of bonds issued increases • Another way to say this: Stock returns increase linearly as a function of the firm’s debt-to-equity ratio (B / S)

29. Interpreting M & M II • As a firm becomes more levered, the risk of owning the company’s stock increases • We know from previous lectures that riskier stocks have higher values of ß • M & M II tells us how increasing the amount of bonds issued increases the company’s risk of stock ownership

30. Criticisms of M & M You do not need to read Section 16.5 • Modigliani and Miller were aware of their shortcomings in their paper • For example, taxes and bankruptcy costs were not considered • We will not go through the differences in M & M when taxes or bankruptcy is introduced

31. Back to managementdecision-making • Should the firm’s management have the goal of maximizing… • …the value of the firm? • …the value of each stock? • …the likelihood that the firm stays in business? • …something else? Could management be trying to maximize something not listed here?

32. Decision making that is not in the best interest of the firm • Some managers are not interested in maximizing firm value • If managers are rewarded for big successes and not punished for failure, we would likely see managers make high-risk decisions, since this will likely result in the highest likelihood of a big success • Many of these decisions are not in the best interests of the firm

33. Financial complexity • Today, we applied M & M concepts with only stocks and bonds • In reality, there are more complicated ways to finance a company • Firm managers may attempt maneuvers to try to make a company look more valuable than it really is • For example, the manager may try to hide some of a firm’s debt • The manager’s compensation may be tied to the stock price at a point in time

34. Finis • This is the end of the material for this class • I hope that you have enjoyed this class • Look on GauchoSpace for days and times of office hours for the TAs and me between now and the final

35. Materials for Final • Scantron • Calculator (same type as before) • #2 Pencil • Pen, eraser, and ruler (optional) • No blue book • Photo ID

36. Unit 1: Introduction, present and future value, and other investment rules under certainty • Chapter 1 • Firm types: Sole proprietorship, partnerships, corporations, limited liability companies • Cash flows: Accounting versus financial views • Possible goals of financial management • Do managers act in stockholders’ interests?

37. Unit 1: Introduction, present and future value, and other investment rules under certainty • Chapter 4 • One-period valuation • Present value, future value, net present value • Compounding: Simple and compound interest; compounding frequency • Discounting • Stated annual interest rate vs. effective annual interest rate • Perpetuities and growing perpetuities • Annuities and growing annuities • Loan amortization; partial amortization • Firm value

38. Unit 1: Introduction, present and future value, and other investment rules under certainty • Chapter 5: Sections 1-6 • Payback period method • Discounted payback period method • Internal rate of return (IRR) • Problems using the above methods • Profitability index

39. Unit 1: Introduction, present and future value, and other investment rules under certainty • Parts of Chapter 6 • Sunk costs • Opportunity costs • Erosion and synergy • Nominal versus real interest rates • Nominal versus real cash flows • Equivalent annual cost

40. Unit 2: Decision making under uncertainty • Chapter 7 • Introducing multiple possible costs and benefits for a company • Monte Carlo simulation • Real options • Decision trees

41. Unit 2: Decision making under uncertainty • Most of Chapter 8 • Bond features, including yields, face values, and coupons • Valuing a bond like an annuity • Interest rate risk • Zero coupon bonds • Ownership risk of bonds not issued by the US government • The role of inflation in the bond market • Determinants of bond yields

42. Unit 2: Decision making under uncertainty • Most of Chapter 9 • Dividends and capital gains of stocks • PV of common stocks • Zero growth: perpetuity • Constant percentage growth: growing perpetuity • Differential growth percentages: more complicated (see Figure 9.1, page 275) • Growth opportunities • Price-earnings ratios

43. Unit 3: The relationships between risk and return • Chapter 10 • Total dollar returns • Percentage returns • Dividend yield and capital gain • Holding period returns of various investments • Historical returns (See lecture slides and Table 10.1, pages 314-315) • Averaging returns: arithmetic and geometric averages • Variance and standard deviation • The normal distribution and its role in stock return distributions • Standard errors • The year 2008

44. Unit 3: The relationships between risk and return • Chapter 11 • Multiple-state analysis of stocks • Expected return • Variance • Covariance • Correlation • Variance and standard deviation of portfolios • The efficient set of two assets • Note importance of the minimum variance point • Systematic versus unsystematic risk • CAPM: Market risk premium, expected return on an individual security, the capital market line, ß, the security market line

45. Unit 3: The relationships between risk and return • Chapter 13: Sections 1-7 • Cost of equity • Estimating ß • The relationship between a firm’s cost and the security market line (SML)

46. Unit 4: More on risk, and other issues • Chapter 14: Sections 1-3, 5, and 6, and the summary • Behavioral finance • Implicit financial subsidies • Inefficient reaction to new information • Overreaction and reversion • Slow response • The efficient market hypothesis • Weak, semistrong, and strong form efficiency • Bubbles

47. Unit 4: More on risk, and other issues • Chapter 22: Sections 1-4 and 6-9 • Buying options • Call options • Put options • Selling options • Combining options • Price bounds of options • Factors affecting option values • The Black-Scholes Model • Stocks and bonds as options

48. Unit 4: More on risk, and other issues • Chapter 16: Section 3 and part of Section 4 • Maximizing stockholder interests versus maximizing firm value (and other possible competing interests) • Leverage and its role of increasing stock return risk • M & M Proposition I (no taxes) • All capital structures lead to the same firm value • M & M Proposition II (no taxes) • Expected return on a stock increases with leverage

49. Good luck on the final