Summary Advanced corporate finance papers & lectures

‘’Back to the basics’’
Capital structure; choices regarding finance;
 Internal capital  money already circulating inside the firm
o Retained earnings: profit of a firm which is not paid out as dividend but is used
to invest.
 External capital  money from an outside source, comes in two categories;
o Debt(bondholder): (usually) has no voting rights and senior to equity regarding
payment. Contains less risk due seniority but has a cap on earnings.
o Equity(shareholder): non-fixed cashflow, receive dividend after debt
payments. Often comes along with voting rights. Not capped on earnings (e.g.
good times more gains, bad times no gains/loss)
A shareholder is limited liable for the company. The only loss they can make is the money
invested.
Debt
 Academic leverage =  noted as ‘x’ years of earnings to repay debt
Equity
Debt
 Industrial leverage =
Earningsbefore interest ∧tax
 Mother of all equations in capital structure:
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+ �3��� ������ + �4������ �� ������� + ��
o Tangible assets: should be associated with higher leverage (tangibility: fixed
assets to total assets).
o Market to Book Ratio: indicating of mispricing. If firms issue equities when
share prices are above true value, leverage should be negatively correlated with
market to book rati0
o Firms’ size (log sales): bigger firms should be more leveraged, they’re more
diversified.
o Higher profitability (ROA).
 High profits should be associated with lower leverage (Pecking Order).
Profitable firms prefer internal funds to debt.
 High profits should be associated with higher leverage (Jensen, 1986).
Market of corporate control is effective and forces managers to pay out
cash by levering up.
 Rajan and Zingales: most of the time is negative

Results:
 Tangibility and size positively associated with leverage.
 ROA negatively associated with leverage, consistent with pecking order.
 Market to book negatively associated with leverage.
 The cost of equity is a linear increasing function of the debt/equity ratio


Notes from the paper the Modigliani-Miller propositions after thirty
years
Putt call parity as a MM proposition

,S = C(K) + Ke^-rt – P(K)
Where originally: S= current shareprice, K exercise prise, T the time to maturity, R the riskless rate of
interest, C(K) and P(K) the current prices of the call and put options.

In MM S= value of the firms cash flow, K the face or book value of the firm’s liabilities, C(K) the
market value of the levered shares in the firm, Ke^-rt the market value of the firms debt if it was
riskless. If the value of S at maturity of the debt turn out to be less than K, the shareholders will invoke
limited liability and put the firm back to the creditors. The actual market value of the debt is thus only
Ke^-rt – P(K). P is the value of the share of the shareholders put.


Assumptions in M&M world:
1. Perfect financial markets:
• Competitive: Individuals and firms are price-takers
• Frictionless: No transaction costs, etc.
• All agents are rational
2. All agents have the same information
3. A firm’s cash-foows do not depend on its financial policy (e.g. no bankruptcy
costs)
4. No taxes

Modigliani-Miller propositions & What happens when you also subsidize equity?

Modigliani-Miller identifies as the perfect world and an ideal benchmark to the real world. It
holds under the following assumptions. Explained beneath are the cases where the
assumption does not hold;

1. Perfect financial market: Competitive, frictionless (no transaction and bankruptcy
cost) and all agents are rational
2. Symmetric information: every firm, investor, bank and agent has the same
information.
o Adverse selection: Lemon-peach problem. Which seller has the desired peach
and the hated lemon? Asymmetric information distorts and creates the
problem. Where the buyer has more information than the seller. Resulting in
good companies to leave and bad companies to remain in the market. Situation
where sellers and buyers have different information (adverse selection)
o Pecking order theory is a result of adverse selection: Asymmetric information
causes the external finance to be more expensive than internal finance. Debt is
less costly than equity. (retained earnings are more preferred to debt and
equity, whereas debt is more preferred than equity)
Retained earnings>Debt>Equity
3. Firm’s cash flow does not depend on its financial policy (assuming no bankruptcy
cost):

o Cost of financial distress:
costs which arise from
bankruptcy or distortion are
categorized in two  Distress
will cause selfish strategies
executed by equity holder;

,  Direct cost: Legal and administrative costs of such an event (lawyer,
bankruptcy filing)
 Indirect cost: cost which arises from disability to keep the firm in business
(lost sales, face loss)
o Selfish strategy 1: Incentive by equity holder to bear high risk;
In case of liquidation
bondholders are senior to
equity holders. Therefore,
equity holders often remain
unpaid. Shareholders are
willing to take negative NPV
projects bearing high risks.
‘’Win big, lose big’’. 10%
chance on $1000 and 90%
on $0 seams feasible in an
event of bankruptcy. Equity
holders hereby have a 10%
chance of ‘reviving’ the
company and a 90%
chance of killing the
company – taking into
account that they are NOT
liable and will lose their
investment if they do
nothing.




o Selfish strategy 2: Underinvestment; rejecting positive NPV projects
In case of an investment opportunity where the firm has a lack of cash,
equity holders have to fill up the gap. Often, investing more cash results
in a net loss of their money and a gain for the bondholders. ‘’ The firm
has $200 and needs $300 for an investment opportunity and will result
in an $18 profit over time. Bondholders will receive a positive NPV by
the fact that equity holders fill up to invest. (Reminder: Debt is senior
to equity) – Equity holders will only get a little proportion after debt is
paid, and likely does not cover the investment. Reject a positive NPV
project is most likely.

350
NPV =−300+ =18.18
1.10
• To Bondholder = $300
• To Stockholder = ($350 - $300) = $50
• The equity holder only gets 50 back from the initial investment of 100 and the
present value for the investment is negative. Therefore, the shareholder owould not
like to invest.

• PV of Bonds With the Project = $.1 = $272.73

, • PV of Stocks with the project = $.1 - $100 = -$54.55

o Selfish strategy 3: Milking the property – liquidation to equity holders
Liquidate existing funds (closely prior to bankruptcy) in form of
dividends or share repurchase. Equity hereby gets senior to debt,
shareholders receive everything and bondholders nothing – Violates
covenant most probably
4. No taxes – often less tax on debt than on equity
o Efficiency: Taxes and subsidies may change otherwise socially optimal
decisions
o Financial stability: Companies may issue too much debt (low on tax) and
pressure the banking system.
Debt x r d x taxrate
PV of Tax shield= =Debt x taxrate
rd
Firm value = value of all equity + debt + Present value of tax shield.




The graph describes the tradeoff between the tax shield created by debt and the cost of
financial distress.
Whenever the following hold 4 propositions will arise which will help to focus on the real
issue, NPV;
1. MM proposition 1: total market value of the firm is independent to the capital
structure (leverage). Namely so that VL=VU. This equation allows to state that the
V=D+E and without corporate taxes the capital structure is irrelevant.

2. MM proposition 2: the firm’s
cost of equity increases with its
debt to equity ratio. Meaning
that debt is cheaper than equity
whereas equity is a riskier cash
flow stream than debt.
If WACC >r d, r E is increasing
D
with
E