Choices of Finance.
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Internal or External.
External: Debt or Equity.
Statistic of Debt/Equity ratio.
Question: Is a high ratio bad?
Does financial planning matter?
• Practitioneers devote a lot of attention to it.
Leverage. Dividend policy.
• D/E in Cement industry is 20 times D/E
ratio in Pharmaceuticals. Why?
• What are the important issues?
Clientele Theory
• Also called financial marketing.
• Investors with heterogeneous preferences and
needs value the same cash flow streams
differently.
• Financial policy choices affect the match between
the security and clientele.
• Therefore, financial policy affects the firm’s
value!!
For instance, an all-equity firm may fail to exploit
the demands for both riskier and safer securities.
M&M (Debt Policy Doesn’t Matter)
• Modigliani & Miller
(MM 1:Debt Irrelevance)
– When there are no taxes and capital markets
function well, it makes no difference whether
the firm borrows or individual shareholders
borrow. Therefore, the market value of a
company does not depend on its capital
structure.
M&M (Debt Policy Doesn’t Matter)
Assumptions
• Frictionless and competitive markets.
• Individuals can take same financial transactions as
the firms and at same cost.
• The firms’ financing and operating decisions are
independent.
• Capital structure does not affect cash flows e.g...
– No taxes
– No bankruptcy costs
– No effect on management incentives
M&M intuition
• Idea was revolutionary in the 50’s (won them the
Nobel Prize).
• Investors’ preferences are over cash flows not
securities.
• If they can make the same transactions as firms at
the same prices, they will not pay a premium for
firms to take such transactions.
• Put differently, if investors can reverse the firms’
financial decisions, these decisions are immaterial.
Arbitrage Proof.
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Two firms: V1=D1+E1, V2=E2.
Both generate random X from same distribution.
Firm 1 debt holders receive r * D1.
Firm 1 equity holders receive X-r*D1.
Firm 2 equity holders receive X
If V2>V1, it is profitable to sell E2 and buy V1.
If V1>V2, it is profitable to sell E1 (borrow D1)
and buy V2.
M&M thoughts
• Yogi Berra said "You better cut the pizza in four
pieces because I'm not hungry enough to eat six."
• A dairy farmer cannot make more money by
skimming some of the butter fat and selling it and
skim milk separately even though the butter fat
sells for a higher prices per kg than whole milk.
Other applications.
• Applies to Governments as well (taxes or
borrowing)!
• Modigliani, F. and M. Miller "Corporate
Income Taxes and the Cost of Capital"
American Economic Review, June 1963,
433-443.
• Miller, M., "Debt and Taxes," Journal of
Finance, June 1977, 32, 261-276.
MMII (Leverage Irrelevance)
• Interest rate on corporate debt was 5%.
Stock market averages 11%. How can
financing be irrelevant?
• When debt is risk free, the expected return
on common stock increases linear to the
D/E ratio
D
requity  rassets  (rassets  rdebt )
E
Proof of MMII
ra 
E[ X ]
D
E

rd 
re
V
DE
DE
Rearranging yields
D
re  (ra  rd )  ra
E
Taxes and Bankruptcy
• Interest is tax deductible so savings is
t* Rd * D. Present value is t*Rd*D/ Rd.
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–
Vl is value of leveraged firm,
Vu is value of unleveraged firm
Vl=Vu+t*D
Re=Ru+(Ru-Rd)*(D/E)*(1-t)
Financial Distress
Costs of Financial Distress - Costs arising from
bankruptcy or distorted business decisions before
bankruptcy. (Enron has over a billion direct
costs).
Market Value =
Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial Distress
Financial Distress
Market Value of The Firm
Maximum value of firm
Costs of
financial distress
PV of interest
tax shields
Value of levered firm
Value of
unlevered
firm
Optimal amount
of debt
Debt
Is this really true (Miller 1977)?
• Bankruptcy costs are not that high.
• If income tax rate is progressive: higher
income, more taxes.
• Then general equilibrium effects will cause
rates such that the corporate tax shield is
equal to the personal income tax.
• This means that the MM results return!!
Pecking Order Hypothesis
• Managers know more than outside investors.
• This explains why a new issue lowers the price
(they wouldn’t do it if they felt the stock was
undervalued).
• Firms prefer internal financing in order not to send
adverse signals that may lower the stock price.
• If external financing is required, they issue debt
first and then equity in order to avoid this bad
signal.
Trade-off Theory
• The optimal D/E structure depends upon the tradeoff between interest tax shields and what financial
troubles are out there.
• Companies with safe, tangible assets ought to have
high D/Es.
• Companies with risky, intangible assets ought to
rely on equity.
• Highly profitable firms sometimes don’t take on
debt, like MSFT, JNJ but GE has 4.25
Financial Slack
• Financial Slack is valuable in order to let
bond holders feel that the bonds are risk
free.
• Financial Slack may have a cost in that
financial distress gives strong incentives for
managers (especially entrenched ones) to
work their butts off.
Moral hazard.
• What happens if all assets are not in place?
• Switching to a riskier project is
advantageous to share-holders.
• Why? On plus side, bond holders don’t
gain, but loose more on the minus side since
chance of default goes up.
• May invest in Negative NPV projects!!
• Does convertible bonds help alleviate this?
JB
• JB Manufacturing is an all equity firm. The equity
is worth £2 million. The cost (return) of equity is
18%. JB pays no taxes. JB plans on issuing
£400,000 in debt and use the proceeds to
repurchase equity. The cost (return) of debt is
10%.
• What will the cost of capital (return on assets) be
after repurchase?
• What will the return of equity be?
Market Efficiency
Market Efficiency Theory
Capital markets reflect all relevant
information. You cannot consistently earn
excess profits.
Efficient Capital Markets - Financial markets in
which security prices rapidly reflect all relevant
information about asset values.
Random Walk - Security prices change randomly,
with no predictable trends or patterns.
Random Walk Theory
• The movement of stock prices from day to
day DO NOT reflect any pattern.
• Statistically speaking, the movement of
stock prices is random (skewed positive over the
long term).
Random Walk Theory
Coin Toss Game
Heads
Heads
$106.09
$103.00
Tails
$100.43
$100.00
Heads
Tails
$100.43
$97.50
Tails
$95.06
Market Efficiency
Technical Analysts - Investors who attempt to
identify over- or undervalued stocks by searching
for patterns in past prices.
Fundamental Analysts - Analysts who attempt to
fund under- or overvalued securities by analyzing
fundamental information, such as earnings, asset
values, and business prospects.
Once a profit making opportunity is discovered, it will
be competed away.
Market Efficiency
Weak Form Efficiency - Market prices rapidly
reflect all information contained in the history
of past prices.
Semi-Strong Form Efficiency - Market prices
reflect all publicly available information.
Strong Form Efficiency - Market prices reflect
all information that could in principle be used
to determine true value.
Todd’s trip to work
• Two paths to work: Beit Oren and Hof Carmel.
• There is construction on the Beit Oren path
starting on Sunday.
• Weak form of travel efficiency, after a day or so
paths will take the same time.
• Semi-Strong form, if announced beforehand, that
day paths will take the same time.
• Strong form, as long as one of the city planners
know, that day paths will take the same time.
Lessons of Market Efficiency
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Markets have no memory
Trust market prices
There are no financial illusions
Do it yourself diversification (worry
about transaction costs).
Markets are good at aggregating
information.
• Experiment by Charles Plott.
• State of world is either X, Y or Z.
• A stock has highest value in state Z and
lowest in X.
• Bidders are given different signals. For
instance if state Z half are given not X and
half Y.
• Miracle: Price of stock went to actual value.
Prediction Markets
• Began with Iowa electronic presidential
market.
• Used then at HP.
• Now Google uses it.
• Also there is intrade and tradesports.
• Tried to use it for Terrorism.
• Read Wisdom of Crowds if you are
interested.
Prediction Markets
• People have taken market efficiency in
reverse.
• If markets are efficient then they reflect
information available.
• If we want to find out this information, run
a market..
Market now.
• We are going to run a presidential prediction
market (for fun)..
• Asset X will pay 100 shekels if Obama wins and 0
shekels otherwise.
• Asset Y will pay 100 shekels if McCain wins and
0 otherwises.
• Even teams will start with 5 of asset X, odd teams
will start with 5 of asset Y.
• Both teams will start with 500 shekels
endowment..