FINA2222 Corporate Financial Policy

Week 1:Introduction & Capital Structure in a Perfect market

Todays plan
Learning objectives Introduction Equity Versus Debt Financing
Capital Structure Financing a Firm with 100% Equity Financing a Firm with Debt and Equity The Effect of Leverage on Risk and Return

Modigliani-Miller I: Leverage, Arbitrage, and Firm Value

Law of One Price Homemade Leverage The Market Value Balance Sheet
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Learning Objectives
Understand the irrelevance of capital structure in perfect markets. Appreciate the impact of leverage on equity and discuss the difference between operational & financial risk.

Understand the law of One Price.

Introduction
CFP goal: Can the financing (capital structure) decision add value to the firm? Quiz: If you simultaneously released a feather and 10-kg bar barbells from the top of the Leaning Tower of Pisa, which would hit the ground first? Perfect markets (no taxes, information asymmetry or other market frictions) Is capital structure relevant? The value in the financing decision comes from its interaction with market imperfections, e.g.:
taxes, information asymmetry costs (e.g. agency costs), financial distress costs, bankruptcy costs.

Capital Structures

In sum, capital structure is: the relative proportions of debt, equity, and other securities that a firm has outstanding.
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Equity Versus Debt Financing: Financing a Firm with 100% Equity

You are considering an investment opportunity.
Initial investment of $800 this year. Project will generate cash flows of either $1400 or $900 next year depending on the economy - assume weak or strong economy is equally likely.

Projected Cash Flows

Date 0 -800 1400 Date 1 Strong Economy Weak Economy 900

Given the project cost of capital is 15%, what is the NPV of this investment opportunity?

If you finance this project using only equity, how much 6 would you be willing to pay for the project?

Equity Versus Debt Financing: Unlevered Equity

Unlevered Equity - Equity in a firm with no debt Because there is no debt, the cash flows of the unlevered equity are equal to those of the project.
Date 0 Initial Value 1000 Date 1: Cash Flows Strong Weak Economy Economy 1400 900 Date 1: Returns Strong Weak Economy Economy 40% -10%

What is the expected return on the unlevered equity?

Equity Versus Debt Financing: Financing a Firm with Debt & Equity
Levered Equity - Equity in a firm that also has debt outstanding You decide to borrow $500 initially, in addition to selling equity. The debt is risk free and you can borrow at the risk-free interest rate of 5%. You will owe the debt holders:$500 1.05 = $525, in one year. Given the firms $525 debt obligation, your shareholders will receive only:
$875 ($1400 $525 = $875) if the economy is strong; and $375 ($900 $525 = $375) if the economy is weak.

For how much can you sell the equity?

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Equity Versus Debt Financing: Financing a Firm with Debt & Equity
Project cash flows:
Date 0 Strong Economy 525 875 1400 Date 1 Weak Economy 525 375 900

Debt Levered Equity Firm

500 E=? 1000

Modigliani and Miller (1958) argued that with perfect capital markets, the total value of a firm should not depend on its capital structure. They reasoned that the firms total cash flows still equal the cash flows of the project, and therefore have the same present value.
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Equity Versus Debt Financing: Financing a Firm with Debt & Equity
Law of One Price: Assets that provide exactly equivalent cash flow payoffs for all future outcomes must sell for the same price. Because the cash flows of the debt and equity sum to the cash flows of the project, by the Law of One Price the combined values of debt and equity must be $1000. Value of the levered equity: E = $1000 $500 = $500.

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Equity Versus Debt Financing: Financing a Firm with Debt & Equity
Law of One Price: Assets that provide exactly equivalent cash flow payoffs for all future outcomes must sell for the same price. While the levered equity has a lower total value, you (the entrepreneur) are not worse off. You will still raise a total of $1000 by issuing both debt and levered equity. Consequently, you would be indifferent between these two choices for the firms capital structure. Because the cash flows of levered equity are smaller than those of unlevered equity, the levered equity has lower total value ($500 versus $1000).
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Equity Versus Debt Financing: The effect of leverage on risk and return
Equity holders face two kinds of risk
Operational risk Financial risk

Leverage increases the risk of equity even when there is no risk that the firm will default.
While debt may be cheaper, its use raises the cost of capital for equity. Considering both sources of capital together, the firms average cost of capital with leverage is the same as for the unlevered firm.
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Equity Versus Debt Financing: The effect of leverage on risk and return
Therefore, it is inappropriate to discount the cash flows of levered equity at the same discount rate of 15% that you used for unlevered equity. Investors in levered equity will require a higher expected return to compensate for the increased risk.
Date 0 Initial Value Debt Levered equity Unlevered Equity (i.e., Total Firm)
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500 500 1000

Date 1: Cash Flows Strong Weak Econom Econom y y 525 525 875 1400 375 900

Date 1: Returns Strong Econom y 5% Weak Expecte Econom d Return y 5% 5%

40%

-10%

15%

Equity Versus Debt Financing: The effect of leverage on risk and return
The returns to equity holders are very different with and without leverage.
Unlevered equity has a return of either 40% or 10%, for an expected return of 15%. Levered equity has higher risk, with a return of either 75% or 25%.
To compensate for this risk, levered equity holders receive a higher expected return of 25%.

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Equity Versus Debt Financing: The effect of leverage on risk and return

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Modigliani-Miller I: Leverage, Arbitrage, and Firm Value

Law of one price

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Modigliani-Miller I: Leverage, Arbitrage, and Firm Value

Law of one price

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Modigliani-Miller I: Leverage, Arbitrage, and Firm Value

Homemade Leverage

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Modigliani-Miller I: Leverage, Arbitrage, and Firm Value

Homemade Leverage

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Modigliani-Miller I: Leverage, Arbitrage, and Firm Value

Homemade Leverage

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Modigliani-Miller I: Leverage, Arbitrage, and Firm Value

Market value balance sheet

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Modigliani-Miller I: Leverage, Arbitrage, and Firm Value

Market value balance sheet

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Tutorial Questions for next week

Chapter 14 Problems 2, 3, 5, 6 and 7

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