Corporate Finance

Corporate Finance part of FDM

MM theorem:

1. What is the key problem for the CFO?

2. How is debt defined?

3. How is equity defined?

4. Which has seinority?

1. What is the optimal capital structure between debt and equity

2. Debt is a nominal amount P, repaid at a fixed date.

3. Equity is the residual CF after debt is repaid.

4. Debt has seniority

MM theorem: Risk:

1. Why is equity risky?

2. Why is debt risky?

3. Is there a risk-premium?

4. Which return is normally assumed to be higher?

1. Equity is risky, since firms invest in risky assets, so chance of failure.

2. Debt is risky, since if firms fail debt can possibly be defaulted on.

3. Yes, since there is systematic risk, a higher risk will increase premium.

4. Equity, since debt has seniorty.

MM 1.theorem.

1. What is the key idea?

2. What asset model is MM build on?

3. How do investors value any claim i?

4. Why do the risk on equity increase as debt increases?

5. What is the result of the theorem?

1. Financing a project costs the same regardles of debt of equity is used.

2. It is build on the AFP model, such that we use state prices.

3. Any claim is valued as: pi = d_f'*v_if + d_S+v_iS

4. Debt is cheaper because it is less risky, but when more debt is added the risk increase, and equity becomes more risky.

5. The total value of firms is unchanged regardless of financing (Asset = Liabilities).

MM 1.theorem: Assumptions

1. Competitive securities market, what does that mean?

2. No taxes or insurance costs, what does that mean?

3. Neutral Capital Structure, what does that mean?

1. Prices reflects the present value of future Cash Flows.

2. Claims on CF are costless to issue.

3. The capital strucutre does not affects the CF or siginal future performance (for instance low balance etc).

MM 1.Theorem, with initial investment

If we assume investors make an intitial investment A.

1. Does that change the result of the theorem if investors finance project with selling equity in future CF or financing all with debt.

1. No, there is no difference, since the NPV of ifnancing with all equity or all debt is the same.

MM: Risk and return

1. What the formular for the net return over the horizon?

2. What is the expected return then?

3. How can we rewrite it so express prices?

4. What is the meaning of this result?

1. The net return is just: r = v/p -1

2. Taking the eexpectation yields: E[r] = E[v]/p -1.

3. We can then isolate p, p = E[V]/(1+E[r]).

4. Securities are priced as the expected CF discounted by its expected return.

MM 2. Theorem.

1. What is the basic idea?

2. What is the meaning?

3. What is a leverage premium?

4. Why is there a premium?

1. In perfect capital markets the expected return on equity satisfies:

E[R_E] = E[R_U] + D/E*(E[R_U] - E[R_D]).

2. Meaning that the expected equity is the expected CF return + a leverage premium.

3. The leverage premium is the higher risk equity holders bear due to debt financing.

4. As debt increase, fixed payment to creditors reduce the residual CF, and equity becomes more leveraged.

MM: Cost of capital

1. What is the formula for the pre-tax WACC?

2. What does WACC mean?

3. What is the main result?

1. r_wacc = E[r_u] = D/(D+E)*E[R_D] + E/(D+E)*E[r_E]

2. Is weighted average cost of capital and reflects the total required return of the project.

3. There is trade-off between equity and debt that ensures that the overall cost of capital does not change in a perfect capital market.

MM: From a CAPM point of view:

A portfolio of risky assets as a beta, as the weighted average beta_p = sum(x_i * beta_i).

1. Write up the equation for the portfolios beta with D and E.

2. Rewrite it to the MM 2.theorem form.

3. What is the meaning of this?

1. betaU = D/(D+E)*betaD + E/(D+E)*betaE

2. betaE = betaU + D/E * (betaU - betaD)

3. Equity risk is increasing in the portion of debt in the capital structure.

MM with debt and taxes:

1. What was the main result from perfect capital markets?

2. How does real life differ from this?

3. What is the present value of the debt promise?

4. What is the interst payment then?

1. MM theory cannot predict how assets CF should be divided into D and E.

2. Special tax treatment of interest payments on debt, motivates firm to optimize their financing structure.

3. The promised amount P, is valued as: D = (d_f + d_s)* P.

4. The interest paid is thus (P - D).

MM with debt and taxes: Levered vs unlevered firm:

1. What is the firm value of a levered firm?

2. What is the firm value of a unlevered firm?

3. What is the tax-shield?

4. What does this mean for MM 1.theorem?

1. Equity + Debt:

V^L = d_F CF_F + d_S [CF_S - tau_C * EBIT + tau_C(P-D)]

2. If we set P = 0, D = 0, we get:

V^U = d_F CF_F + d_S [CF_S - tau_C * EBIT]

3. The tax shiled is just the difference V^L - V^U = tau_C(P-D)

4. It breaksdown, as firm value now increase with the tax-shield.

MM with debt and taxes: WACC with tax-shield

1. How does the formular for WACC change now?

2. What is then the after-tax effective borrowing?

3. What is the formular:

1. r_wacc = E[r_u] = D/(D+E)*E[R_D] * ( 1- tau_C) + E/(D+E)*E[r_E]

2. P* = P - tau_C (P - D). I.e. the effective repayment since we save on corporate tax.

3. r_wacc = r_u * (1-tau_C)

MM with debt and taxes: Investor taxation

1. Equity holders:

   1. What do they pay in taxes?

   2. Form what amount?

   3. What do they receive?

2. Debt holders:

   1. What do they pay in taxes?

   2. Form what amount?

   3. What do they receive?

3. Is this a problem and what does tax-systems try?

1. Equity holders:

   1. They pay tau_e in taxes.

   2. From the corporate profits.

   3. They receive (1-tau_C)*(1-tau_E)

2. Debt holders:

   1. They pay tau_i

   2. From cash realized CF.

   3. They receive (1-tau_i)

3. No directly, but it creates a gap, such that tax-system try to neutralize the difference.

MM with debt and taxes: Effective tax advantage.

1. What is the effective tax advantage?

2. What is the formular?

3. What happens if r*>0?

4. Why is this a problem for more risky firms?

5. Why is this a problem for high-growth firms?

1. The effective tax-rate express the difference between the equity and debt tax-rate.

2. r* = 1- [equity tax] / [debt tax]

3. There is a tax advantage of debt, that increase firm value by taking on an amount in debt.

4. Firms with frequent periods of failure are more risky, and thus gain less from tax-shields, (not succees that often).

5. Lower curent earnings means lower advantage from debt financing.

MM and Capital Structure with taxes and default costs

1. What have we learned so far from MM?

2. What is the basic idea?

1. Special tax treatment, impose that a until a certain point higher debt increase firm value.

2. There exists a trade-off between the level of debt from the tax-advantage and the risk of default.

MM: Default costs of debt I

1. What happens if C_F <. P, and fail happens?

2. Why does creditors not receive C_f in this case

1. A firm will default (bankrupt).

2. Since a fraction goes to legal and administrative costs, creditors only receive p*C_F (p is rho here).

MM: Default costs of debt II:

Explain the following in words and the formula

1. What is the value of creditors position?

2. What is the value of equity holders?

3. What is the value of the firm when levered?

4. How much does default cots reduce firm value?

1. Is value of the claim in the fail state (rho*C_F) and the value of actually receiving the promise: D = d_f*p*C_F + d_SP

2. Is the value of the residual CF from succes: E = d_S(C_S - P)

3. The value of the firm is the equity. +debt.

   V^L = E + D = d_f*p*C_F + d_SC_S

4. Is the fraction cash flow in fail state that goes to administrative costs etc. d_f*(1-rho)*C_F.

MM: Trade-off theory.

1. What is financial distress costs, give some examples.

2. What is the benefit of debt?

3. What. is the cost of debt?

4. What is the trade-off?

1. Costs that arise before default as the probablity increase with higher debt promises. For instance, employee uncertianty, loss of costumers and suppliers etc.

2. Debt provides financial gain though tax shields.

3. Debt introduces financial distress costs.

4. The trade-off is choosing the optimal amount of debt that maximize firm value.

MM: Incentives from Capital Structure

1. What is the idea?

2. Who are insiders and outsiders?

3. Give examples of insider actions?

1. After securing financing, insiders may take decisions that impact CF (choosing a more risky project or visa versa).

2. Equity holders are insiders, creditors are outsiders.

3. Asset substition and underinvestment

MM: Examples of insider actions

1. What are an asset substitution?

2. What is an underinvestment?

1. Insider choose a riskier strategy, increasing C_S but lowers C_F. Value of debt decrease, and value of equity increase.

2. Insiders avoid project that increase C_F because the benefits go primarily to creditors. Equity holders receive little or no benefit because creditors have senioirty. (IS called Debt-hang).

MM: Assymetric information and capital structure

1. What is problem of adverse selection?

2. What is the pecking order theory?

3. How can signaling help 1)?

1. Insiders have privat info about the firms true type (high/low CF streams). Outsiders cannot distinguish, offers terms based on average of all firm types. Weaker firms accept funding (profit), stronger firms reject (loss). = Market ineffiency.

2. Due. to asymmetric information, firms perfer financing in this order.

   1. Its own cash (No asymmetric info).

   2. Issuing safe debt

   3. Issuing riskier debt

   4. Issuing equity

3. Strong firms can signal their strength by actions that are to costly for weaker firms. For instance, costly intermediaries, posting collateral to creditors, retaining. morerisk etc.

MM and dividend policy:

1. What is thee focus here?

2. What are the main questions?

1. Primarly on how firms handle cash once investment project start paying off.

2. Which payout policy should it follow? Keep money in the firm?, PAy dividens or repurchase shares? Buy back debt?

MM and dividens policy: Simple example:

Consider a firm with the following CF_F=20, CF_S=120,

1. what is the value of the firm if d_F=0.5 and d_s = 0.4?

If the firm possses cash of 45, in addition to the risky asset.

2. What the 4 options the firm has?

1. It is: V^U = 20×0.5 + 120×0.4 = 58

2. The firm can:

   1. Retain cash

   2. Repay crediots

   3. Pay dividens to equity holders

   4. Repurchase shares

MM - Keeping the cash.

A firm has 45 in Cash from prior operation. CF is 20 (fail, or 120(fail). d_F = 0.5 and d_S = 0.4. The firm can choose to keep the cash.

1. What is the value of the cash in the future?

2. What is the Future CF´s now?

3. What is the new value of the firm?

4. What is the insight?

1. 45 = 0.9*V → V = 50.

2. Is is just CF_F = 20+50 = 70 and CS_S = 120+50

3. The value of the firm is then V = 0.5×70+170×0.4=103.

4. In perfect market the value of the firms risky asset plus cash, is simply the sum of the values.

MM - Repaying the creditors.

Suppose the firm promises P > 50 to crediots, and decides to pay out 45 to crediots. And CF = 20 (fail)

1. What is the new debt promise?

2. What is the value of the creditors?

3. What are the result?

1. The new debt becomes: P’ = P - 50

2. Creditors value is: 45 + d_F*min{20,P’} + d_S*P’

3. Since min{20,P’} = min{70,P} - 50. The crediots are indifferent.

MM: Pay dividens to equity holders

The firm can use all 45 to pay dividend to shareholders.

1. If debt has been promised (P > 20), what is the value of the debiotrs position now at fail?

2. What is the insight?

1. It is min{20,P} < min{70,P}

2. Thus paying dividens harms creditors by redistributing firm value from crediots to shareholders.

MM: Repurchase shares.

Alternatively, the firm can use the 45 to buy back shares in the market. CF = 20 (fail) or CF = 120 (succes).

1. After the repurchase, the value of debt is?

2. What is share holders value?

3. What is the insight?

1. D = d_F min{20, P} + d_S*min{120,p}

2. The share holders value is E = V^U - D

3. In perfect capital markets, shareholders are indifferent between dividens and share repurchases.

MM : Dividend policy

In perfect capital markets, what are the lessons?

1. Retaining cash makes future CF safer, why is that, and what does it say?

2. If dividend policy is fixed then what?

1. Since the risk of default creases, then firm should redistribute value from share holders to creditors if debt is risky.

2. It is:

   1. Creditors invest only the value of the CF they actually receive.

   2. Shareholders are indifferent to dividend policy before creditors are financed.

   3. The value of the firm is unchanged.

MM: Dividend policy - introducing taxation.

Market imperfections, such as taxation can alter the results.

1. What does tax threatment difference do?

2. What does it imply for optimal payoff policy?

1. CF to shareholders as divident and capital gains are taxed differently.

2. Shareholders prefer the policy that minimizes their tax payments.