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
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
