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Summary Advanced Corporate Finance Part 1: F. Braggion
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Lecture notes and Summary of Advanced Corporate Finance. This contains the part of F. Braggion 2017/2018
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Advanced Corporate FinanceLecture 1:
Review of Finance Source
Internal Capital
Retained earnings: Profits not paid back to shareholders but used to finance investment,
current expenses.
External Capital
Debt
o Debtholders have a contract specifying that their claim must be paid in full before
the firm can make payments to the equity holders
o Usually debtholders do not have voting rights
o Debt is a senior claim to equity
Equity
o Equity holders receive a dividend only after the debtholders claims are satisfied
o Equity holders have the right to vote at the general meeting of shareholders
Academic Leverage Industry / Practical Leverage
𝐷𝑒𝑏𝑡 𝐷𝑒𝑏𝑡 𝐷𝑒𝑏𝑡
or
𝐸𝑞𝑢𝑖𝑡𝑦 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝐵𝐼𝑇
Leverage can change because of:
1. Debt is issued or paid back
2. Equity is issued or paid back
According to MM I, finance does not matter for firm value
Modigliani-Miller Irrelevance Theorem
Assumptions
1. Perfect financial markets:
o Competitive: Individuals and firms are price-takers
o Frictionless: No transaction costs, etc.
o All agents are rational
2. All agents have the same information
3. A firm’s cash-flows do not depend on its financial policy (e.g. no bankruptcy costs)
4. No taxes
The original propositions:
MM-Proposition I (MM 1958): A firm’s total market value is independent of its capital
structure
MM-Proposition II (MM 1958): A firm’s cost of equity increases with its debt-equity ratio
Dividend Irrelevance (MM 1961): A firm’s total market value is independent of its dividend
policy
Investor Indifference (Stiglitz 1969): Individual investors are indifferent to all firms’ financial
policies
,MM-Proposition I (MM 1958): A firm’s total market value is independent of its capital structure
Value of a firm: Present Discounted value of Future Cash Flows
When a firm issues debt and equity securities, it splits its cash flows into two streams:
o Safe stream to bondholders
o Risky stream to stockholders
M&M Proposition 1:
o Firms cannot change the total value of their securities by splitting cash flows into two
different streams
o Firm value is determined by the real assets
o Capital structure is irrelevant
MM-Proposition II (MM 1958): A firm’s cost of equity increases with its debt-equity ratio1
The Firm Weighted Average Cost of Capital is:
𝐷 𝐸
𝑊𝐴𝐶𝐶 = 𝑟𝑑 + 𝑟
(𝐷 + 𝐸) (𝐷 + 𝐸) 𝐸
𝐷
𝑟𝐸 = (𝑊𝐴𝐶𝐶 − 𝑟𝑑 ) + 𝑊𝐴𝐶𝐶
𝐸
𝐷
If 𝑊𝐴𝐶𝐶 > 𝑟𝑑 , 𝑟𝐸 is increasing with 𝐸
Intuition: increasing Debt makes equity riskier, increasing the expected returns investors demand
Debt generates risk
Higher debt ratios lead to greater risk and higher required returns (to compensate for the
additional risk)
Risk
Business Risk: is the typical enterprise risk a firm faces
Financial Risk: Risk of the equity investment.
Debt is playing a role!
In the second picture:
Business risk stays the same (as when it was financed totally with
equity) Business risk is the risk of the entrepreneur. Financial is the
risk that arises from financing.
-You have more volatility per unit debt.
using debts -> in good times, could push returns up a much
Bad times -> go down very hard.
,Financial Risk
The additional risk placed on the common stockholders as a result of the decision to finance
with debt:
1. Debt is senior to equity: interests and principal payment have to be made before any
cash is distributed to the shareholders
2. If the company is liquidated:
debtholders have the right to a fixed claim – the amount of the their debt
Gain or losses are taken over by the shareholders
Leverage increases shareholder risk 𝐷
Leverage also increases the return on equity (to compensate for the higher risk) 𝛽𝐿 = 𝛽𝑈 (1 + )
𝐸
Dividend Irrelevance (MM 1961): A firm’s total market value is independent of its dividend policy
Investor Indifference (Stiglitz 1969): Individual investors are indifferent to all firms’ financial policies
M&M v.s Win-Win Fallacy: Debt is better because some investors prefer debt to equity
Clientèles Theory (or Financial Marketing Theory):
Different investors prefer different consumption streams
They may prefer different financial assets
Financial policy serves these different clientèles
Example: All-equity firms might fail to exploit investors’ demands for safe and risky assets. It may be
better to issue both debt and equity to allow investors to focus on their preferred asset mix
Intuition from MM: investors’ preferences are over consumption, not assets.
Investors can make their own decisions, like homemade leverage if the firm is all-equity financed.
• If investors can undertake the same transactions as firms, they will not pay a premium for
firms to undertake them on their behalf ⇒ No value in financial marketing
Conclusion: if the assumptions hold, any combination of securities is as good as any other.
The morale of proposition 4:
Managers should not care about the risk preferences of the investors
We just need that investors have the ability to borrow and lend for their own account (and at
the same rate as firms) so that they can “undo” any changes in firm’s capital structure
Using MM sensibly:
MM is not a literal statement about the real world
But it helps you to ask the right question:
How does finance change the size of the pie?
, MM’s most basic message:
o Value is created only (i.e. in practice mostly) by operating assets, i.e. on Left Hand
Side of the Balance Sheet
o A firm’s financial policy should be (mostly) a means to support the operating
policy, not (generally) an end in itself
MM helps you avoid first-order mistakes
Taxes
Usually corporations pay less taxes on debt than equity. This is important:
Efficiency: introduction of taxes and subsidies may distort otherwise socially optimal
decisions
Financial stability: companies may issue “too much” debt, putting pressure on the banking
system
Finance still does not have a clear idea of the impact of taxes on debt.
Evidence is found in the fact that there are only a few significant changes in corporate taxes.
These changes were mostly concentrated on large firms and nearly after corporate scandals.
M&M with taxes
Tax does also impact the capital structure and firm value
through the Tax Shield.
Paper: What happens when you subsidize equity?
The NID (Notional Interest Deduction) is an explicit equity deduction introduced in Belgium in 2006
with the objective of reducing the tax-driven distortions that favor the use of debt financing
The NID allows firms to deduct from their taxable income a notional charge equal to the product of
the book value of equity times a benchmark interest rate based on historical long-term government
bonds
The results were significant meaning that Belgium companies took more equity when the NID was
active in comparing to the control countries. It also seems that this effect is larger for large firms
(Belgium *2006) than for small firms ( [Belgium*2006] – [Belgium*2006*Small]). For the small firms
we need to deduct this coefficient from the large firms to find the coefficient of the large companies.
Taking more equity implies a lower leverage ratio.
, Introducing Bankruptcy costs
Costs of financial distress: Cost arising from bankruptcy
or distorted business decisions before bankruptcy.
Direct costs: legal and administrative costs
Indirect Costs
o Impaired ability to conduct business (e.g., lost sales)
o Selfish strategy 1: Incentive to take large risks
Implies taking negative NPV projects
o Selfish strategy 2: Incentive toward underinvestment
Implies that the firm does not have enough money to take on a positive NPV project.
o Selfish Strategy 3: “Milking the property”
Liquidating dividends
Suppose our firm paid out a $200 dividend to the shareholders. This
leaves the firm insolvent, with nothing for the bondholders, but
plenty for the former shareholders
Such tactics often violate bond covenants
Increase perquisites to shareholders and/or management
Trade-off theory of capital structure.
There is a trade-off between the tax advantage of
debt and the cost of financial distress.
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