BEEM117
Economics of Corporate Finance
Lecture 1
Some announcements
• Course information (slides, homework, etc.)
– http://people.exeter.ac.uk/maf206/ecf.htm
– Office hours: 13:30-15:30 on Mondays
• “Main” textbook:
– Tirole, J. The Theory of Corporate Finance, 2006
– Available in the library and bookstore.
• Other references will be in week’s handout
Some announcements
• Warning:
– Basing your study on lecture slides alone is a fatal mistake!
– These slides will NOT contain all relevant information for the
exam.
– You must do the required readings/homework every week!
• Assessment:
– 100% exam;
– Exam will consist of 6 questions, of which you must answer
any 3.
Some announcements
• Each week we will meet for two hours:
– 1st hour will cover new material;
– 2nd hour will cover homework and questions.
• The purpose of the 2nd hour is to review old
material and address any questions you have.
– If you haven’t done the work, it’s usefulness will be
limited.
– Also it is a good opportunity to provide feedback
regarding the class.
Corporate Finance
• We will start by recognising there are two
different ways a firm can finance itself:
– It can issue stocks (Equity);
– It can borrow money from investors (Debt).
• Debt can be thought as simply a claim on the
income generated by the firm.
• Equity holders receive any remaining profit
– They are “residual claimants”.
Corporate Finance
• Claims to the firm’s revenues can be stratified
further, depending on type of debt/equity:
– 1. Secured Debt:
– 2. Ordinary Debt:
• Senior
• Junior/Subordinated
– 3. Preferred Stock:
– 4. Common Stock:
Debt vs. Equity
• Why pay attention to whether firms issue debt
or equity?
• Does this decision impact the value of a firm?
• Modigliani and Miller devoted their attention to
this question in the late 1950’s and had a
striking (and Nobel prize-winning) answer:
– Under some conditions, the value of the firm is
unaffected by the combination of debt and equity.
The Value of a Firm:
Definitions and simplifying assumptions
• ‘The firm’ is an incorporated limited liability
company.
• Firm’s equity is tradable and is of only one type
– common stock, denoted as S.
• Firm’s can also raise capital by issuing bonds,
B, which are also marketable.
The Value of a Firm:
Definitions and simplifying assumptions
• V is the total market value of the firm:
– V = B + S.
• Leverage ratio = B/S.
• Firm must make financial outlays at certain
dates to bond holders.
• Failure to do so (i.e. revenues < debt
repayments) results in bankruptcy.
The Value of a Firm
• A traditional approach to finance argued that
market value of the firm is inversely related to
its cost of capital.
• Suppose a firm has zero debt:
• Issuing debt in exchange for its equity reduces
its cost of capital (why?)
• Equity is related to profitability of firm, while
debt repayments are pre-determined.
The Value of a Firm
• Hence equity is a riskier investment than debt.
• Also if debt levels are low, risk of bankruptcy is
negligible.
• As debt levels rise the possibility of default goes
up and that increases the cost of capital.
The Value of a Firm
WACC
• Assume firms maximise their market value;
• Let:
–
–
–
–
B/S express a firm’s leverage;
ρ denote a firms WACC;
i denote the rate of return on equity;
r denote the rate of return on bonds.
• Then:
S
B
  i r
V V
WACC
• Because V = S + B, we can re-write S/V and B/V as
functions of leverage.
S
1
B
B/S

, 
V 1  (B / S ) V 1  (B / S )
• We can re-express WACC as:
1
B/S

i
r
1  (B / S ) 1  (B / S )
WACC
• Take an example of a firm which has 60% of its
financing through equity and 40% via bonds.
– The leverage of the firm is therefore 0.6/0.4 = 2/3.
• The interest rate on its debt is 10% and the expected
rate of return to equity holders is 15%.
– ρ = 0.6 x 0.15 + 0.4 x 0.1 = 0.13
• As B/S goes up, so does the risk of bankruptcy:
– Bondholders demand higher returns on their investment,
making debt less attractive,
– Hence the U-shape of the WACC
Modigliani-Miller (MM)
• MM’s work in the late 1950’s completely changed the
way economists perceive this question.
• They argued that under certain conditions, the value of
the firm is independent of its leverage. (MM-1)
• That is, the shape of the ρ function is a flat line
• This means the cost of equity must be a function of
leverage. (MM-2)
MM-1
Assumptions
• Existence of risk classes
– A risk class is a set of firms with identical earnings across
different states of the world.
• Taxes are neutral
– The tax rate is the same for all firms and the same for all
types of earnings.
• Frictionless capital markets
– Zero transaction costs
– No restrictions on asset trades
MM-1
Assumptions
• Investors can borrow on the same terms as
firms
• Firms’ financial policy convey no information
about earnings across states of the world
• No Bankruptcy
– Earnings are assumed to be higher than debt
payments across all states of the world.
MM-1
• There are k states of the world, each of whom
occurs with probability pk.
• The value of the firm’s assets (or it’s revenue)
in state k is Xk.
– Therefore firm’s earnings are also uncertain.
• Once the true state of the world is revealed, so
are firm’s earnings.
MM-1
• Bond holders are promised a payment equal to
Z, which is assumed to be constant across k.
– By assumption Xk > Z
• Equity holders’ payment is a function of Xk.
– In particular, it is equal to max(Xk – Z,0).
• So, does the mix of equity and debt matter for
the value of the firm?
MM-1
• Consider two different firms, U and L.
– U is unlevered
– L has issued bonds with market value BL
– U and L are exactly identity in all other regards
• Suppose firm L sets Z=600 on its bonds and also that
BL is equal to 500.
• There are two states of the world such that:
– X1 = 1500 and X2 = 700
• Finally, suppose the market value of both firms is 1000
MM-1
MM-1
• If both firms’ value is the same, a 1%
investment in either firm yields the same payoff
in every state of the world.
• If this is not true, an investor could construct an
arbitrage portfolio:
– With a zero capital outlay, generate non-negative
payoffs in all states and strictly positive in at least
one state.
MM-2
• The second MM theorem states that the firm’s cost of
equity capital is a linear function of its debt-to-equity
ratio.
• To show this we must state some definitions:
– Cost of equity capital:
– Cost of bond finance:
– Cost of capital (WACC):
E( X )  Z
1 i 
S
Z
1 r 
B
E( X )
1  
V
MM-2
• MM-2 states that the following linear relationship holds:
B
i    (  r)
S
• As the cost of bond finance goes up, the smaller the effect the
leverage ratio has on the cost of equity.
• Conversely, the higher the leverage ratio, the higher the cost of
equity.
• Note, however, that ρ is invariant wrt B/S as per the last slide.