The Miller & Modigliani theorem. Turning to capital structure. The two key questions in corporate finance: Valuation : How do we distinguish between good investment projects and bad ones? Financing : How should we finance the investment projects we choose to undertake?
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The two key questions in corporate finance:
3. The external financing is done by issues of debt, equity and hybrid securities (such as convertible debt and preferred equity)
5. Sources of financing vary over time and over business cycle
*D/(D+E), Debt in book value, Equity in market value
- Debt is senior to equity → get the value of the firm until debt paid off
(2) Division of control
Payment to debt holders, D(V).
Payment to Equity holders, E(V).
Face of debt
Face of debt
→ Optimal capital structure
When is it true that financing is irrelevant?
return on assets
rE = rA + (D/E)(rA-rD)
βE = βA + (D/E)(βA – βD)
Debt becomes risky
3. Prices reflect all existing information (strong form efficiency)
→ Could potentially issue misvalued securities and make money!
Cash = Negative debt!
Debt – Excess Cash when we evaluate capital structure and unlever betas.
4. No differential tax treatment.
5. No costs of financial distress.
6. No issuance costs.
7. Managers and employees do not have an incentive to deviate from +NPV rule.
The value of firm is Cash + VU + PVTS= $500 + 600 + 200 = $1300
The value of equity is
E = $1300 - $500 = $800
Share price increased from $0.60 to $0.80
→equity gets the whole $200 gain of the new debt tax shield!
Value of the firm is now $1300 - $500 = $800
E = V – D = $800 - $500 = $300
The equity market cap is lower, but equity holders wealth consist of $300 in stock + $500 in cash = $800
→ Pre-tax profits increase by $10M/yr (perpetuity) if TC=40%, after tax profits are $6M/yr
→ Keeping $100 of excess cash in the firm, rather than paying it out, reduces value of cash to $60!
- Average debt ratio has been around 35% in last decades.
- Many firms (Microsoft, Intel) hoard large amount of cash.
Either CFO’s are missing something, or something must be missing from our analysis.
→ less likely to have profits left to shield with additional debt
Can lead to value destruction that would not have happened in the absence of debt
Example: K-Mart spent more than $ 100 million on lawyers, accountants, investment bankers, and other advisors wile in bankruptcy.
→ Less time and ability to run regular operations!
Suppose a levered firm is choosing between two projects with equal NPV, one of which is riskier than the other. Are equity- and debt holders indifferent between the two?
Value in a year
Cash flow in a year
2. Equity holders are reluctant to contribute capital to safe projects, even when they have positive NPV: Underinvestment / Debt overhang
3. Anything that increases risk of debt without destroying value decreases value of debt and increases value of equity
→ Will demand higher interest rates when firm borrows in the firms place
→ Will impose covenants restricting firm behavior
V(with debt) = V(all equity) + PV(tax shield) – PV(costs of distress)
PV (costs of distress) =
Probability of distress increases with leverage and decreases with excess cash.
PV (costs of distress) increases with leverage and decreases with excess cash.