Modern Finance
Capital Structures and Risk Management
University of Minnesota
Masters in Financial Mathematics Orientation
August 31, 2010
Gary Hatfield
Agenda
•
•
•
•
What is Capital?
Typed of Capital and Capital Structure
Capital Asset Pricing Model (CAPM)
Modigliani – Miller (M&M)
– Without Corporate Income Taxes
– With Taxes
•
•
2
Why is M&M not practiced?
Why do risk management?
Gary Hatfield
What is Capital?
•
•
Dictionary: accumulated goods devoted to the
production of other goods
Example:
– You want to start a business that makes and
sells ice cream to retail customers
– You need money to purchase ice cream making
equipment, freezers, milk sugar, not to mention a
store; this is capital
– But you do not have enough money
3
Gary Hatfield
What is Capital?
•
For the small business owner, capital can be
raised via
– Own savings
– Business partner (investor)
– Bank loan
•
4
For large endeavors however, this typically
insufficient.
Gary Hatfield
Types of Capital
•
•
•
•
5
How to raise a large amount of capital?
Rather than finding a small number of very
wealthy investors, find a large number of
investors (who may or may not be individually
wealthy)
Stocks: Each share represents partial
ownership in the firm
Bonds: Basically, “I.O.U’s” issued by the firm
and can traded by the initial investors
Gary Hatfield
Types of Capital
•
Keys to success of stocks of bonds
– Limited liability of investors
– Transparent and publically available information
on issuing firms
– Liquid markets that allow stocks and bonds to be
traded
6
Gary Hatfield
Capital Structure
•
Capital Structure refers to
– How the firm has raised capital for its ventures
– How the profits and losses of the firm are divided
among its investors
•
7
Generally speaking, this can be thought of in
terms of how much capital is raised via stocks
versus via bonds
Gary Hatfield
Capital Structure
•
Stocks and bonds:
– Bond holders get first rights to profits up to
amount of IOU
– Stock holder are entitled to all profits beyond the
bond IOU’s
•
8
Within each class (stocks and bonds), there can
be further delineation of priority
Gary Hatfield
Capital Structure (Priority)
•
Stocks
1. (Higher) Preferred stock
•
•
•
Preferred stock pays a regular dividend (so long
as funds are available)
Preferred stock holders have no voting rights (i.e.
no say in how the company is run)
Preferred stock holders get nothing extra when
profits are high
2. (lower) Common stock
•
•
9
Gary Hatfield
Shareholders have control of the firm
Shareholders entitled to all excess profits
Capital Structure (Priority)
•
Bonds
1. Senior – secured (certain assets pledged as
collateral)
2. Senior – unsecured
3. Subordinated
10
Gary Hatfield
Capital Asset Pricing Model (CAPM)
•
Basic assumptions
– Investors are risk averse and rational
– Hence, for a given level of risk, investors prefer
investments with the highest expected return
– Equivalently, for a given level of expected return,
investors prefer investments with the lowest
amount of risk
– Standard deviation of returns is a good measure
of risk
– All investors have the same view of risks and
returns for all securities
11
Gary Hatfield
CAPM
•
For each level of risk, the portfolio of risky assets with the
highest expected return is called “efficient”
•
The set of efficient portfolios for many levels of risk is called
the “efficient frontier” of risky assets
12.00%
Efficient Frontier
10.00%
Return
8.00%
6.00%
4.00%
2.00%
0.00%
0.00%
12
Gary Hatfield
5.00%
10.00%
Risk
15.00%
20.00%
CAPM
•
•
Suppose the risk-free investment yielding 4% is available, then the
efficient frontier of all investments is combination of the risk free asset and
an efficient risky portfolio
This is also called the Capital Market Line
12.00%
Efficient Frontier
10.00%
Return
8.00%
6.00%
4.00%
2.00%
0.00%
0.00%
13
Gary Hatfield
5.00%
10.00%
Risk
15.00%
20.00%
The Market Portfolio
•
•
•
14
The efficient risky portfolio whose tangent line
intercepts with the risk free asset is therefore
held in every efficient portfolio that includes the
risk free asset as a choice
Under the assumption of homogenous
investors, this portfolio is the only risky asset
portfolio that investors will hold (along with risk
free bonds)
This portfolio is called the Market Portfolio
Gary Hatfield
The Market Portfolio and beta
•
•
The expected return on any given asset depends
only its covariance with the market portfolio
(because otherwise one could construct an even
more efficient portfolio)
Mathematically, the expected return on a security
can be written:
Rasset  Rriskfree   asset Rmarket  Rriskfree
where
15
Gary Hatfield
Cov(asset , market)
 asset 
Variance (market)
The Market Portfolio and beta
•
•
•
16
Since beta depends only on the correlation with
the market portfolio, it follows that variance in
the returns that are uncorrelated with the market
makes no difference in terms of the expected
return of the security (equivalently, its price)
In other words, the risk of a firm specific to that
firm, called idiosyncratic risk, does not matter to
investors
The basic argument is that idiosyncratic risks
can be diversified away
Gary Hatfield
CAPM
•
Since firm specific risks earn no risk premium, it
“follows” that risk management is of little value
– Reducing beta accomplishes nothing, since
those risks cannot be reduced without paying risk
premium equal to the amount of value added (i.e.
you can only reduce beta risk by shorting the
market)
– Reducing idiosyncratic risk is only an expense
because idiosyncratic risks are not priced
•
17
More on why these conclusions are likely not
true later
Gary Hatfield
Modigliani and Miller (M&M)
•
•
•
18
Back to capital structure
An important question for firms seeking to raise
capital is to find the right combination of stock
versus bond
Goal is to find the combination that maximizes
the value the shareholder’s claims (since they
are the owners)
Gary Hatfield
M&M
•
Modigliani and Milled assumed
– No corporate income taxes
– No bankruptcy costs
=> Capital Structure is irrelevant!
19
Gary Hatfield
M&M (add taxes)
•
•
•
20
In the U.S., firms pay 35% corporate income tax
M&M showed: in the presence of corporate
income taxes (everything else being the same),
corporations should raise as much capital via
bonds as possible (simple reason: interest paid
on bonds is tax deductable but dividends are
not)
But clearly this is not the observed practice
Gary Hatfield
Why do companies not issue as
much bonds as possible?
•
•
21
Bankruptcy costs – higher debt levels increase
the probability of default
This explains part of the answer, but is of
questionable value because the stock holders
are not responsible for bankruptcy costs
Gary Hatfield
Risk Management and Capital
Structure
•
22
•
One the one hand, naïve financial models suggest;
– Risk management adds no value
– Firms should lever as much as possible (issue mostly
bonds and little equity)
On the other hand,
– Most companies expend a lot of money on risk
management
– Most companies do not lever to the hilt(Fannie and Freddie
excepted )
•
Why?
Gary Hatfield
Value of the firm (to stock holders)
•
•
•
•
23
Firm Value = Value of Assets – Value of Debt +
put option + franchise value
Value of Assets – Value of Debt = liquidation
value
Put option refers to stockholders right to walk
away without further liability
Franchise value refers to present value of all
future profits
Gary Hatfield
Value of the Firm
•
Hypothesis:
– Failure to manage risk and too much leverage
increase the likelihood of financial ruin
– Financial ruin destroys franchise value
•
However, if franchise value is easily created by
deploying financial capital, then the argument
does not work
– Investors would more happily fund a start up than
an under water existing firm
24
Gary Hatfield
Value of the Firm
•
•
But if franchise value is not easily created
simply by deploying financial assets, then there
is a good reason to avoid ruin
Consider:
–
–
–
–
•
25
Reputation
Brand
Distribution and business relationships
Human Capital
Contrast: airlines versus life insurers
Gary Hatfield
Summary
•
•
•
•
•
•
26
Capital is the money needed to create goods
The composition and form of a firm’s capital is
its capital structure
CAPM suggests no reason to manage risk
M&M suggests levering to the max
Observed practice suggests otherwise
Hypothesis: Franchise Value is more easily
destroyed than created
Gary Hatfield