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Summary for the course 'Advanced Corporate Finance'. This summary was written in order to study for the final. Everything you need to know is available in this summary.
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,Lecture 1 – Revision and introduction
Financial sources:
1. Internal capital:
- Retained earnings: profits that are kept within the company to invest back into the
company.
2. External capital:
- Debt: borrowed money to be paid back with interest.
→ Debt holders usually have no voting rights.
→ Debt is senior to equity (receive money before equity holders).
- Capital: compensated with dividend, which is dependent on company performance.
→ Equity holders have voting rights.
Leverage definitions:
Academic leverage:
Industry leverage:
➔ Indicated with 3X or 4X etc.
Meaning: X years of earnings to pay back entire debt.
Modigliani-Miller irrelevance theorem:
Perfect world:
Assumptions:
1. Perfect financial markets:
- Competitive (price takers)
- Frictionless (no transaction costs)
- Rational agents
2. Equal information among agents:
- No inside information, no information asymmetry, etc.
3. No bankruptcy costs
4. No taxes
MM-Proposition I:
- Firm value = PV(FCF) (future cash flows)
- Firm value is independent of capital structure.
- Firm value = real assets (cash flow equity + cash flow debt)
- ‘’The size of the pie is what matters, not HOW we slice it’’
Notation:
VU = VE = (EBIT) / rU (rU = required return on unlevered equity)
VL = D + E = ((interest + (EBIT – interest)) / rU (same as above just added CF of interest)
VE = VL – value of debt (of a levered company)
3
, MM-Proposition II:
- Cost of equity increases with its D/E ratio.
- WACC: rate that a company is expected to pay on average to all its security holders
- RWACC = RU (cause then D = 0) = RA
-
- If WACC > rD, then rE is
increasing with D/E
- Higher debt makes equity
riskier → higher rE
Business risk: firm risk, which is not related to debt
Financial risk: risk of the equity investment
➔ Unlevered firm: business risk = financial risk, because assets = equity (intertwined)
➔ Levered firm: higher financial risk, because equity has become riskier
→ Equity has to absorb everything instead of debt.
→ Debt is senior to equity
→ Absorb 10% vs 20% of initial investment
→ Higher rE = higher compensation
4
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