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Samenvatting - Corporate finance

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Summary Corporate Finance IBA

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  • May 4, 2024
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  • 2021/2022
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SUMMARY CORPORATE FINANCE
BASIC CONCEPTS OF FINANCE

‘’Risk is priced’’

- Your perception of the risk from a purchase/investment affects your willingness to pay
- They end up affecting the value of that item to you, and the price of the item

What is a financial asset?

- It is the means to a goal  saving/investing/getting rich?
- It is a contract

The prescription from finance

- The normative approach to the value of a financial asset (a bond, a stock, a call option, an insurance
contract)…
- …is the present-value calculation
- You should accept to pay price P for a financial asset if: P < present-value of future payments from the
asset

CHAPTER 14 – CAPITAL STRUCTURE IN A PERFECT CAPITAL MARKET

EQUITY VS. DEBT FINANCING

Capital structure

- Firms can be financed through mainly two different instruments:
1. Equity  investors provide some funds and receive part of the future cash flows (if positive)
2. Debt  investors provide some funds and they receive the same amount plus some interest in
the future (if possible)
- The question in this part of the course is  which financing method makes a firm more valuable?

Differences debt equity

1. Debt’s maximum payout is fixed  when you issue debt, you never pay more than the amount
borrowed + interest rate. On the other hand, equity holders earn all the cash flows
2. Debt is senior to equity  firms must pay to the debt holders, and the remaining money (if any)
is payed to the equity holders

Levered equity is riskier than unlevered equity

More leverage leads to

- High risk for shareholders
- Higher expected return for shareholders

But…

, - Return on asset remains constant
- Cash flows do not change

MODIGLIANI-MILLER I: LEVERAGE, ARBITRAGE, AND FIRM VALUE

Proposition 1

Modigliani and Miller (MM) showed that leverage does not affect the total value of the firm under a set of
conditions referred to as perfect capital markets:

- Investors and firms can trade the same set of securities at competitive market prices equal to the
present value of their future cash flows
- There are no taxes, transaction costs, or issuance costs associated with security trading
- A firm’s financing decisions do not change the cash flows generate by its investments, nor do they
reveal new information about them

Miller (1997)

‘’It’s after the ball game, and the pizza man comes up to Yogi Berra and he says: Yogi, how do you want me to
cut this pizza, intro quarters? Yogi says: No, cut it into eight pieces, I’m feeling hungry tonight’’

Homemade leverage

- Investors love leverage
- Firm values are the same whether the firm is unlevered or levered
- Homemade leverage = when investors use leverage in their own portfolios to adjust the leverage
choice made by the firm

Note: excess cash

- Sometimes firms’ balance sheet includes cash or other risk-free assets
- These securities reduce the risk of firm assets
- Then, they have the opposite effect as leverage
- Thus, we consider them as ‘’negative debt’’, that is, what we call debts is actually net debt (debt -
excess cash)

Leverage recap = an operation in which we increase the leverage of the firm, without changing the actual cash
flow of the firm (Modigliani-Miller still applies)  higher debt compared to equity

MODIGLIANI-MILLER II: LEVERAGE, RISK, AND THE COST OF CAPITAL

Some notation

- A = Market Value (MV) cash flows generated by assets
- U = value unlevered firm
- E = MV equity
- D = MV debt
- PCM = perfect capital market



Cost of equity

, - Recall MM I: A = U = D + E
- The Law of One Price implies:



- Return on levered equity



- Note:




Return and Beta

- Higher return must imply a higher market risk
- In particular the asset’s betas:




Or



- Therefore, increasing leverage increases the firm’s betas

CAPITAL STRUCTURE FALLACIES

Two capital structure fallacies

1. More leverage increases Earning per Share (EPS), then stock price should increase
2. Issuing capital increases the number of shares, therefore share prices should decrease

Fallacy = an often-plausible argument using false or invalid inference

EPS fallacy

- EPS without leverage = Earnings / Number of shares
- Share price = Dividends / Cost of Capital

, Debt-financed buyback

- NSO = number of shares outstanding
- NSO = previous NSO – number of shares bought
- Number of shares bought = amount spent / share price
- EPS = earnings / NSO = EBIT – interest / NSO

Leverages recap

- Modigliani-Miller  share price is the same!
- We can check it by:
1. Compute the cost of capital



2. Discount the dividends




Summary of EPS fallacy

- More leverage might increase EPS
- But also makes the EPS more risky
 Leverage does not affect the share price

Equity issuance fallacy

- The firm increases value because the new shares attract new capital
- The asset side of the firm grows as much as the new capital
- That is, new shareholders bring their own piece of pizza!

CHAPTER 15 – DEBT & TAXES

INTRO

With perfect capital markets:

- No taxes, no transaction cost and no issuance costs
- Financing decisions do not affect expected cash flows
- Price of a security equals the present value of all future expected cash flows

Capital structure does not affect firm value!

This chapter  there are taxes

INTEREST TAX SHIELD

The interest tax deduction

- Firms pay taxes according to the profits they earn
- Profits = earnings – operating costs - … - interest payments
- Therefore, debt reduces taxes paid by firms
- With leverage, profits are lower but the total amount paid to investors is higher

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