Ondernemingsfinanciering En Vermogensmarkten (323622B6)
Instelling
Tilburg University (UVT)
Boek
Corporate Finance
Samenvatting van alle colleges van ondernemingsfinanciering en vermogensmarkten gebaseerd op het boek van Berk en Demarzo. De samenvatting bevat alle relevante stof voor het examen. De samenvatting is net als het tentamen in het Engels.
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Ondernemingsfinanciering En Vermogensmarkten (323622B6)
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Samenvatting ondernemingsfinanciering en vermogensmarkten
Introduction
NPV and market value
• Investment project within a firm
◦ Investment outlay I0 = Capital expenditure + ΔNWC
◦ Projected cash flows E(CFt ), using all-equity fiction
◦ Cost of capital, applicable to the project (rp )
• Project value = PV =
◦ = current market value of additional cash flow stream for the firm
◦ but this is only obtainable after paying the investment outlay I0
• Net Present Value = NPV = PV − I0
• NPV is identical to the increase in firm market value: NPV = ∆V
Project discount rate (rp )
• Reflects the risk embedded in the project cash flows
• As perceived by the capital market
• Only the systematic part of the risk is relevant (CAPM)
• Which is measured by the project’s beta-coefficient (β)
• The project’s risk (βp ) is not necessarily equal to that of the existing projects in the firm (β)
• Therefore
What is still missing?
• In determining expected cash flows, we continue to use the all-equity assumption
• But firms are usually financed with equity and debt -> Not in the expected cash flows, but in
the relevant cost of capital
• rwacc = weighted average cost of capital
• Use information sources in order to calculate the equity beta (βE )
• Determine the equity cost of capital (rE ) using the CAPM
• Determine the beta of debt (βD ) and the cost of debt capital (rD )
• Combine this into the weighted average cost of capital
• Use this rwacc to discount the (all-equity) expected cash flows
,Chapter 14
Condensed balance sheet
Adjusted balance sheet
• This defines (net) productive assets as closely as possible
• This asset total is financed by capital market investors by using explicit financing
agreements or securities
Case: start up a new firm
• Strategy, management team (MT)
• Business plan is ready, which includes current investment:
◦ Capital expenditures in fixed assets, i.e. CapEx
◦ Operational net working capital, i.e. ΔNWC
• It also includes expected cash flows, resulting from investing and pursuing the strategy
• However: MT-members are not able to fund the investment outlay themselves
• So they have to attract external capital and issue securities on the capital market
• What capital structure should the MT choose?
• I.e. what relative proportions (or “package”) of debt, equity and other securities should they
issue in order to finance the firm’s initial investment
• Business plan reveals:
◦ Investment outlay = 800 at time 0
◦ Cash flow at time 1 is depending on the state of the economy: 1400 (strong) or 900
(weak), with equal probability
◦ The current risk-free interest rate rf is 5%
◦ The projected cash flows depend on the state of the economy and therefore contain
market risk
◦ Capital markets are expected to demand a risk premium for this type of risk of 10%
over the current risk-free interest rate
• So rwacc is equal to 15%
,All-equity financing
• Since its NPV is positive, this is an interesting investment project
• But it can only be executed after the initial funding is provided for
• Suppose the MT resorts to all-equity financing, what amount can it raise from a share issue?
◦ We call this unlevered equity = equity in a firm with no debt
◦ The unlevered equity cash flows are equal to that of the firm
◦ Assuming that the capital markets are competitive, outside investors are willing to
pay up to 1000 in return for 100% of the equity, since
Unlevered equity returns
• Expected unlevered equity return =
• This is a fair return (expected return is the same as cost of capital)
Levered equity alternative
• Suppose the MT considers the following alternative financing package
◦ Borrow 500 (debt)
◦ Issue equity for the remainder (levered equity = equity in a firm that also has debt
outstanding)
• Even the lowest cash flow outcome is large enough to repay the debt with interest, so the
debt is entirely risk-free
◦ The MT can borrow at the risk-free rate in competitive capital markets (i.e. at 5%)
◦ And the total debt payment is 500(1.05) = 525 (= interest + repayment)
• Note that the company’s cash flow will now be divided between the debt and equity
providers
Law of One Price
• The cash flows of both debt and levered equity sum to the firm’s cash flow
• By the Law of One Price, the combined debt and equity package value must be equal to
1000
• So the levered equity value is equal to 500
Deciding between both financing packages
• The cash flows of levered equity are smaller than those of unlevered equity
• So the issue amount of levered equity is lower than with unlevered equity
• But the total financing package still yields 1000
, • And the MT will be indifferent between both packages
Leverage and return on equity
• Levered equity cash flows are not only smaller, but the spread in levered equity returns is
also higher: levered equity is more risky
• So levered equity cash flows may not be discounted at the same (unlevered) discount rate
• We should use a higher discount rate
Expect returns on (un)levered equity
• The risk premium is twice as high for levered equity
• Levered equity holders require 25% return in order to compensate them for the increased
risk
Cost of capital and leverage
• So rwacc is equal in both the unlevered and levered financing packages
• The suggested advantage of cheaper debt is annihilated by a compensating rise in the cost of
levered equity, such that for the market value of the firm
EU = 𝐕𝐔 = 𝐕𝐋 = EL + D
• There is no net present value to be created by choosing whatever financing package
• This is the famous Proposition I of Modigliani and Miller (MM I)
• rwacc does not change for different values of debt
• Cost of levered equity rises sharply for higher debt levels
Modigliani-Miller I (MM I)
• MM I holds under a set of conditions that defines a perfect capital market:
◦ 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 generated by its
investments, nor do they reveal new information about them
• In such a setting, the Law of One Price implies that leverage will not affect the total value of
the firm
◦ Total firm value is equal to the market value generated by its assets and is not
affected by its choice of capital structure
◦ Leverage only changes the allocation of cash flows between debt and equity, without
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