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Financial Economics


UNIT III | CORPORATE FINANCE

CHAPTER 14- AN OVERVIEW OF CORPORATE FINANCING

Much of the money for new investments comes from profits that companies retain and reinvest. The
remainder comes from selling new debt or equity securities.

PATTERNS OF CORPORATE FINANCING
Corporations invest in long-term assets (property, plant, equipment) and in net working capital (current
assets minus current liabilities). Firms may raise funds from-

1. EXTERNAL SOURCES: Firms may raise funds from external sources-

Debt
Equity sources
Lenders have first claim on cash & Stockholder receives leftover cash after the lenders are paid.
But they have complete control of the firm, providing that they keep their promises to lender.

2. INTERNAL SOURCES: Firms plow back their profits into the business. Indian corporations get the
cash to pay for these investments- most of the cash is generated internally. This internally
generated cash comes from-
Retained earnings (earnings not paid as dividends)
Cash flow allocated to depreciation

If NPV>0 => Shareholders want to use internal funds back into the firm => Increase in
shareholders value. But sometimes internal cash flow doesnt cover investment and the
company faces a financial deficit. To cover the deficit, the company must cut back on dividends
to increase retained earnings, raise new debt and raise equity capital from outside investors.
Internal financing covers most of the cash needed for investment because its easily obtainable
and more convenient than external financing.

The mix of debt and equity financing varies from industry to industry and firm to firm and overtime.

AGGREGATE BALANCE SHEET OF MANUFACTURING CORPORATIONS IN INDIA- Aggregate balance sheet
of all Indian manufacturing corporations is the balance sheet if all Indian businesses were merged into a
single gigantic firm.

ASSETS:
Current Assets = Inventories + Receivables+ Loans & advances given + Cash
Net fixed assets= Gross fixed assets depreciation
Investments

LIABILITIES:
Current liabilities

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Secured & Unsecured loan
Shareholders equity= Share capital + Reserves & Surpluses

DEBT RATIO=DEBT / DEBT + EQUITY

In book-value terms the debt ratio crept upward until 1990. So book debt ratio (doesnt depend on
market conditions) started declining after 1993 when firms opted to pay down debt.
Market debt ratio (depends on market conditions) decreased in 1992, 2004-07 when stock prices
increased. But in 2008-09, when stock prices declined, the debt ratio increased.
Its true that lower debt ratios mean less number of companies will fall into financial distress when
recession hits the economy. But it should be remembered that debt has risks as well as benefits. So, find
the optimal debt ratio.

Comparing the average ratio of [total liabilities/ total liabilities+ equity] for the manufacturing industry
in a sample of countries, one can see that debt ratio in all the countries is greater than that of India.

TYPES OF SECURITIES

EQUITY DEBT
Common stock Bank loans Floating-rate bonds

Preferred stock Notes Zero- coupon bonds

COMMON STOCK
AUTHORIZED SHARE CAPITAL = Maximum number of shares that can be issued. If management wishes
to increase the number of authorized shares, it needs the agreement of shareholders.
ISSUED SHARES are the fraction of authorized shares that are actually issued/ subscribed.
Eg. RIL issues 327 shares out of 500 authorized shares.
The price of new shares sold to the public almost always exceeds par value. The difference is entered
in the companys accounts as share premium reserves or capital surplus.
Eg. If RIL sold an additional 1 million shares at Rs 100/share (where face value was 10), the share capital
account would increase by 1 million x Rs 10= Rs 10 million and the share premium account would
increase by 1m x Rs 90= Rs 90 million. RIL distributes part of its earnings as dividends and the remainder
can be used to finance new investments.

(Book value is a backward looking measure. It tells us how much capital the firm has raised from
shareholders in the past. It does not measure the value that shareholders place on those shares today.
The market value of the firm is forward looking, it depends on the future dividends that shareholders
expect to receive.)

OWNERSHIP OF THE CORPORATION- EQUITY
A corporation is owned by its ordinary shareholders. Ordinary shares in India are held by:

Promoters (46%) Banks, FIs, Insurance Companies (4%)

Individual Investors (15%) Mutual Funds (2%)
Corporate Bodies (23%) Others (3%)
FIIs (7%)

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If all common stocks are owned solely by CEO, then he receives all the cash flows and makes all
investment and operating decisions => Has complete cash-flow rights and complete control rights. But
these rights are split up and reallocated when a company borrows money-if it takes a bank loan, it
enters into a contract with the bank promising to pay interest and repay the principal. The bank gets
some right to cash flows and the residual cash-flow rights are left with the stockholder. The bank
protects its claim by imposing restrictions on what the firm can or cannot do. For example, it may
require the firm to limit future borrowing. So, the stockholders control rights are limited.
If the firm fails to make the promised payments to the bank, it may be forced into bankruptcy => bank
will be the new owner and will have control rights of ownership.
The common stockholders have residual rights over the cash flows and have ultimate right of control
over the companys affairs- their control is limited to vote for the appointments to the board of
directors, and on other crucial matters such as the decision to merge.
THE DOMINANT SHAREHOLDER is the one who controls 20% or more of the votes of corporations. In
India, this dominant shareholder (known as promoter) controls on avg. about 50% of the votes. The US
lies in the middle of the pack.

VOTING PROCEDURES

Of the total no. of directors, a max of 33% can be permanent directors. At an annual meeting, 33% of
the rotational directors retire and elections take place.
1. MAJORITY VOTING SYSTEM: Here, each director is voted upon separately and stockholders can
cast 1 vote for each share that they own. Eg. If the promoter has 51% of a companys shares,
then the promoter (under the majority voting system) can elect all the directors. Even with the
remaining 49% shares, the minority shareholders will not be able to appoint a single director.
2. CUMULATIVE VOTING SYSTEM: If a companys articles permit cumulative voting, the directors
are voted upon jointly and stockholders can allot all their votes to just one candidate. So,
minority shareholders may be able to elect a director to the board, if they act intelligently.
Eg. If 5 directors are to be elected to the board, then the promoter has 51x5= 255 votes and
minority shareholders have 49x5=245 votes. Then the minority shareholder can elect 2
members by casting 123 votes for the 1st and 122 for the 2nd.

DUAL-CLASS SHARES AND PRIVATE BENEFITS

In 2000, companies were allowed to issue differential shares (which have different voting rights).The
different classes of share can have the same cash-flow rights, but different control rights.
Shares with superior voting power sell at premium because of the private benefit of control (to obtain a
seat on the board of directors). So, investors are basically paying to gain voting rights.
Even when there is only one class of shares, minority stockholders may be at a disadvantage- the
companys cash flow and potential value may be diverted to management or to a few dominant
stockholders holding large blocks of shares.
Financial economists refer to the exploitation of minority shareholders as TUNNELING- the majority
shareholder tunnels into the firm and acquires control of the assets for himself.
REVERSE STOCK SPLITS: Here, the company combines its existing shares into smaller, more convenient
no. of shares. Its generally used by companies with a large number of low-priced shares. As long as all
shareholdings are reduced by same proportion, nobody gains or loses by such a move. Eg- Owner of 3
old shares are now owner of 2 new shares. This reduces the stake of minority shareholder.

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EQUITY IN DISGUISE

Common stocks are issued by corporations. But a few equity securities are issued not by corporations
but by partnerships or trusts. Examples:
1. Partnerships- To get a share in profits of business and receive dividends timely in partnership
firms, one needs to buy units in the partnerships. Partnerships avoid corporate income tax.
Eg. Plains All American Pipeline LP is a partnership that owns crude oil pipelines. You can buy
units in this partnership on the NYSE, thus becoming a limited partner in Plains All American.
2. Trusts and REITs-
Eg. To own a part of the oil in the Prudhoe Bay field, you need to buy a few units of the
Prudhoe Bay Royalty Trust. This trust is the passive owner of a single asset: the right to
a share of the revenues from Prudhoe Bay production.
Real Estate Investment Trusts (REITs) were created to facilitate public investment in
commercial real estate, specialize in lending to real estate developers. REIT shares are
traded just like common stocks though they are restricted to real estate investment.

PREFERRED STOCK
It provides only a small part of most companies cash needs. A company can choose not to pay a
dividend to its common stockholder. Most issues of preferred stocks are known as cumulative preferred
stocks. This means that the firm must pay all past preferred dividends before common stockholders get
anything. If the company misses a preferred shareholders dividend, they generally gain voting rights.

COMMON STOCK PREFERRED STOCK
They are last in line for companys They have a greater claim on companys assets. At the time
assets. of bankruptcy, they are paid before common stockholders

(Dividends on Preferred stocks) > (Dividends on Common stock)

They have the right to vote.

Preferred stockholders dont have vote rights.

DEBT
When companies borrow money, they promise to make regular interest payments and to repay the
principal. However, this liability is limited. Stockholders have the right to default on the debt if they are
willing to hand over the corporations assets to the lenders and they will choose to do this only if the
value of the assets is less than the amount of the debt. Because lenders are not considered to be owners
of the firm, they do not normally have any voting power.
Thus interest is paid from before-tax income, whereas dividends on common, preferred stock are paid
from after-tax income. So, govt provides a tax subsidy for debt that it does not provide for equity.

OWNERSHIP OF DIFFERENT DEBT SECURITIES IN INDIA
Bank (78%) Foreign currency borrowings (11.76%)
Financial institutions (MF, Insurance companies)- (7%) Promoters (0.27%)
Govt. of India (1.6 %) + State govt (0.04%) Others (1.3%)

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DECISIONS

A. Should the company borrow short-term or long-term?
If company needs to finance a temporary increase in inventories => take a short-term bank loan.
If the cash is needed to pay for expansion of a refinery => its appropriate to issue a long-term
bond. Some loans are repaid in a steady way; and some loans are repaid entirely at maturity.
B. Should the debt be fixed or floating rate?
The interest payment on long-term bonds is FIXED at the time of issue- where firm continues to
pay fixed coupon per year regardless of how interest rates fluctuate.
Most bank loans and some bonds offer a VARIABLE/FLOATING rate. Here the ROI in each period
may be set at 1% above MIBOR (Mumbai Interbank Offered Rate), which is the ROI at which
major banks lend $ to each other. When MIBOR changes => the ROI on your loan also changes.
C. Should you borrow dollars or some other currency? Rupee/ Foreign currency loans
Because international bonds have usually been marketed by the London branches of
international banks they have traditionally been known as Eurobonds and the debt is called
Eurocurrency debt. A Eurobond may be denominated in dollars or any other currency.
D. What promises should you make to the lender?
Lenders want to make sure that their debt is as safe as possible. Therefore, they may
demand that their debt is senior (paid before) to other debts. If default occurs, payments
are made in this order- Bondholder > senior debt holder/creditor/lender >
junior/subordinate debt holders > preferred stockholders > common stockholders

The firm may also set aside some of its assets for the protection of creditors. Such debt is
said to be secured debt and the assets that are set aside are known as collateral. If defaults
occurs, the bank can seize the collateral and use it to help pay off the debt.
Firm also provides assurance to the lender that it will not take unreasonable risks.
E. Should you issue straight or convertible bonds?
The owner of a warrant can purchase a set number of the companys shares at a set price before
a set date. A convertible bond gives its owner the option to exchange the bond for a
predetermined number of shares.
If companys share price increases => Convertible bondholder (CBH) converts his bond into
share => profits
If companys share price decreases => No obligation to convert bond into share => CBH remains
a bondholder

OTHER NAMES OF DEBT

ACCOUNTS PAYABLE is obligation to pay for goods that have already been delivered.
RENT/LEASE: Instead of borrowing to buy new equipment, the company may rent/lease it on a
long-term basis. So the firm promises to make lease payments to the owner of the equipment. This
is just like an obligation to make payments on an outstanding loan.
SPECIAL PURPOSE ENTITIES (SPEs): Companies want to ensure that their investors dont know how
much the companies have borrowed. SPEs raise cash by a mixture of equity and debt and then used
these debts to help fund the parent company. None of this debt shows up on companys balance
sheet.

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VARIETY

Financial managers have plenty of choice in designing securities. One can find hybrids that incorporate
features of both debt and equity. The dividing line between debt and equity is hard to locate.
A securitys classification as debt or equity matters for accounting and tax purposes. Its not always right
to say that Debt is safe, equity is risky because there are examples of safe equity (preferred stock) and
risky debt (junk bonds).

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CHAPTER 16- PAYOUT POLICY
Corporations can return/payout cash to their shareholders in 2 ways:

Paying a DIVIDEND- Some companies do not pay any dividends and invest their total profit in
the business itself.
REPURCHASING STOCKS- buy back some of the outstanding shares

There is a trade-off between higher/lower cash dividends and issue/repurchase of common stock.

FACTS ABOUT PAYOUT

1. Till 1998, dividends were the principal way to return cash to shareholders.
2. Indian companies were allowed to buyback shares from 1998 onwards.
3. After 2004, stock purchases have also become common. The percentage of dividend paying
firms in India fell from 24% (2001) to 16% (2009) and then increased to 19% (2010).
4. Once the Directors approve the companys decision to buy back the shares, the company
informs SEBI.

DIVIDEND PAYMENT AND STOCK REPURCHASES
IMPORTANT DATES of a Dividend
DECLARATION DATE - This is the date on which the board of directors announces to
shareholders and the market as a whole that the company will pay a dividend.

EX-DIVIDEND DATE - On or after this date the security trades without its dividend.
If you BUY a dividend paying stock one day before the ex-dividend you will still get the dividend.
If you buy on the ex-dividend date, you won't get the dividend because your purchase will not
be entered on the companys books before the record date. If you want to SELL a stock and still
receive a dividend you need to sell on or after the ex-dividend day

DATE OF RECORD - This is the date on which the company looks at its records to see who are
the shareholders of the company who will receive the dividend payout.

DATE OF PAYMENT- This is the date the company mails out the dividend to the holder of record.

In today's market, settlement of stocks takes 3 days (from the transaction date) for the change to be
entered into the company's record books.
If you are not in the company's record books on the date of record, you won't receive the dividend
payment. So, to ensure that you are in the record books, you need to buy the stock at least 3 business
days before the date of record, which also happens to be the day before the ex-dividend date.

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1 NOVEMBER 5 NOVEMBER 7 NOVEMBER 22 NOVEMBER
DECLARATION EX-DIVIDEND DATE OF DATE OF
DATE DATE RECORD PAYMENT


The company isnt free to declare whatever dividend it chooses. Dividend payments by Indian
companies are regulated by Section 205 of Companies Act- according to which a company can pay a
dividend out of profits for that year after providing for : depreciation and after transferring atleast 10%
of the companys profits to the reserves.
Most companies pay a regular cash dividend each year, but this can be supplemented by (1) Extra or
special dividend. (2) Automatic Dividend Re-Investment Plans (DRIPs) where the new shares are issued
at a discount from the market price. (3) Companies also declare stock dividends. For Eg. If the firm pays
a stock dividend of 50% (1:2), it sends each shareholder 50 extra shares for every 100 shares currently
owned.

IMPORTANCE OF BONUS ISSUES IN INDIA

In April 2009, SEBI made it mandatory for the Indian companies to announce the dividend on a per share
basis and not in percentage basis.

HOW FIRMS REPURCHASE/ BUYBACK STOCKS

According to SEBI (Buyback of securities) Regulation 1998, a company can buy back its shares by-
1. Tender offer to shareholders
2. Open market repurchases
3. Dutch Auction- Shareholders submit offers declaring no. of shares they wish to sell at each price
& the company calculates the lowest price at which it can buy the desired number of shares.
4. Direct negotiation

HOW DO COMPANIES DECIDE ON PAYOUTS?

1. Managers are reluctant to make dividend changes that may have to be reversed.
2. Managers try to avoid reducing the dividend.
3. To avoid the risk of a reduction in payout, managers smooth the dividends.
4. Managers focus more on dividend changes than on absolute levels. Thus paying a $2.00
dividend is an important financial decision if last years dividend was $1.00, but no big deal if last
years dividend was $2.00.

REPURCHASE DIVIDENDS
Under stock repurchasing, corporations buys back Dividend is a payment made by a corporation to its
some of its outstanding shares. shareholders, usually as a distribution of profits.
Its not taxed Its taxed.

THE PAYOUT CONTROVERSY
DIVIDEND POLICY IS IRRELEVANT IN PERFECT CAPITAL MARKETS

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The middle-of-the-road party was founded in 1961 by Miller and Modigliani (MM) - according to them,
a dividend policy is irrelevant in a world without taxes, transaction costs, or other market imperfections.
EXAMPLE- Suppose your firm has settled on its investment program. You have a plan to finance the
investments with cash on hand, additional borrowing, and reinvestment of future earnings. Any surplus
cash is to be paid out as dividends. Lets say, you want to increase the payout by increasing the dividend
without changing the investment and financing policy. If the firm fixes its borrowing, the only way it can
finance the extra dividend is to print more shares and sell them. The new stockholders are going to part
with their money only if their new shares are worth as much as they cost. But how can firm sell more
shares when its assets, investment opportunities & market value are unchanged? So, there is a transfer
of value from the old to new stockholders. The new ones get the newly printed shares, each one worth
less than before the dividend change was announced, and the old ones suffer a capital loss on their
shares.

The capital loss borne by the old shareholders just offsets the extra cash dividend they receive.
So, the total value is unaffected.

2 ways of raising cash for the firms

original shareholders are:
1. If the firm pays a dividend; each
share is worth less as more shares
have to be issued against assets.
2. If the old stockholders sell some of
their shares, each share is worth
the same but the old stockholders
have fewer shares.

In each case the cash received is offset
by a decline in the value of the old
stockholders claim on the firm.

ILLUSRATION OF DIVIDEND IRRELEVANCE

Rational Demiconductors Balance Sheet (Market Values)

CASE 1:

ASSUMPTIONS- Ignore taxes, assume efficient capital markets

Rational Demiconductor has Rs 1,000 cash earmarked for a project requiring Rs 1,000 investment. The
company uses this cash to pay Rs 1,000 dividends to its stockholders- the immediate source of funds is
cash account. But this cash was earmarked for investment project. So, the company continues with the
investment project and so the Rs 1000 are raised by new financing- debt/equity. Lets say, it ends up
financing the dividend with Rs 1000 stock issue.

Cash ($1,000 held for investment) 1,000 Debt 0
Fixed assets 9,000 Equity 10,000 + NPV
Investment opportunity NPV

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Total asset value 10,000 + NPV Value of the firm 10,000 + NPV

Without dividend- The Company gets 10,000 + NPV.
With dividend- New Value of original stockholders share = Value of company Value of new shares
= (10,000+NPV) (1,000) = 9,000 + NPV
But they also get cash dividend of Rs 1,000 => Total = 10,000+NPV

So, their capital loss is offset by cash dividend => Overall market value is unchanged at (10000 + NPV).
So, dividend policy doesnt matter.

If NPV= Rs 2,000, then the old stock is worth Rs 10,000 + NPV = Rs 12,000 => Rs 12,000/1,000 = Rs
12/share. After the company paid dividends, old stock is worth Rs 9,000 + NPV = Rs 11,000 => Rs
11,000/1,000 = Rs 11/share. So, after new stock issue, the stock is valued at Rs 11/share. If stockholder
gets a fair value => Company must issue 91 (=Rs 1000/Rs 11) new shares to raise the needed Rs 1000.

So, the price of the old stock falls by the amount of dividend payment (= Rs 1/share).

CASE 2:

If the new project is a failure, so that NPV=0 => Management discards the project decided above and so
the Rs 1,000 earmarked for it will be paid out as extra dividends.

Cash (held for investment) 0 Debt 0
Fixed assets 9,000 Equity 9,000 + NPV(=0) = 9,000
Investment opportunity for the new project NPV=0
Total asset value 9,000 Value of the firm 9,000

1000 outstanding shares => Stock Price before dividend payment = 10,000/1,000 = Rs 10/share and Rs
9/share after dividend payment.
Had the company used the Rs 1000 to repurchase stocks instead of paying dividends, company buys Rs
1,000/Rs 10 = 100 shares and leaves 900 shares worth Rs 9,000.

So, switching from cash dividends share repurchase, has NO effect on shareholders wealth.
They forgo Rs 1 cash dividend but end up holding shares worth Rs 10 instead of Rs 9.

STOCK REPURCHASES AND VALUATION

Company X has 100 shares outstanding. It earns Rs 1,000 a year, all of which is paid out as a dividend.
The dividend/share = Rs 1,000/100= Rs10/share.

CASE 1: RECEIVE DIVIDEND INDEFINITELY

Suppose that investors expect the dividend to be maintained indefinitely and that they require a return
of 10% (=> r= 0.1) => PVshare = 10/0.1= Rs 100.
The total market value of the equity= PV equity= 100 shares x Rs 100= Rs 10,000.

CASE 2: STOCK PURCHASE IN YEAR 1 FOLLOWED BY DIVIDEND FOR REMAINING (n-1) YEARS

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Suppose the company announces that instead of paying a cash dividend in 1 year, it will spend the same
money repurchasing its shares in the open market.

a) Value of Rs 1000 received from the stock repurchase in year 1= PVrepurchase= A/1+r = Rs 1,000/1.1=909.1
b) Value of the Rs 1,000/year dividend starting in year 2= PVdividends= Rs 1,000/(.10 x 1.1)= Rs 9,091

So the total value of the equity = Rs 1,000/.10 = $10,000 = (a) + (b)
So, the total expected cash flows to shareholders is unchanged at $1,000
So, each share continues to be worth Rs 10,000/100 = Rs 100 as before

Now, the shareholders who plan to sell their stock back to the company will demand a 10% return on
their investment. So the expected price at which the firm buys back shares must be 10% higher than
todays price= Rs 110.

Company spends Rs 1,000 to buy back its stock, which is sufficient to buy Rs 1,000/Rs 110=9.09 shares.
The company starts with 100 shares, it buys back 9.09, and therefore 90.91 shares remain outstanding.
Each of these shares can look forward to a dividend stream of Rs 1,000/90.91= Rs 11/share.
So after the repurchase shareholders have 10% fewer shares, but earnings and dividends per share are
10% higher.


MAIN POINTS (IMP):

1. Other things equal, company value is unaffected by the decision to repurchase stock rather
than to pay a cash dividend.
2. When valuing the entire equity, include both- cash paid out as dividends and stock
repurchases.
3. When calculating the cash flow per share, it is double counting to include both the forecasted
dividends per share and the cash received from repurchase.
4. A firm that repurchases stock instead of paying dividends reduces the number of shares
outstanding but produces an offsetting increase in subsequent earnings & dividends/ share.

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CHAPTER 17- Does Debt Policy Matter?
The Debt Policy of a company refers to the manner in which the company structures its capital. It can be
loosely interpreted as a debt vs equity financing debate, however there is a lot of variety within the debt
structure and also within equity.

Modigliani and Miller (MM) put forth the proposition that in perfect capital markets the payout policy
and financing decisions do not matter. Its real assets, not the securities, evaluate the firm.

We will delve deeper into understanding the imperfections of the market that make a difference and
elevate the importance of capital structure.

Effect of Financial Leverage in a Competitive Tax Free Economy

Financial analysts often want to maximize the value of the firm by using the ideal combination of
securities. MM proved that this would entail maximization of the value to the shareholders.

If company A has 100 shares selling for Rs. 20 each, then the equity (E) raised is Rs. 2000. In addition A
borrows 3000 from the market, which is the Debt (D). Thus, the market value (V) of the company is Rs.
5000 (E+D).

The stock is the levered equity, which exposes the shareholders to financial leverage, or gearing. If A
levers up, it means that it borrows more from the market and distributes it amongst the shareholders as
special dividend. If A borrows 1000 and gives a special dividend of Rs. 10 each, the new debt (D) would
be Rs. 4000. This leaves the values of E and V as unknowns. Since we know that V=E+D, we have:

V=E+5000

Thus, V and E move in the same direction. A policy that maximizes V, will maximize E also.

This rests on the following assumptions:

1. Payout Policy is ignored

2. The new debt doesnt affect the value of the old debt.

Thus, a financial manager will look for a combination of securities that maximizes the firms value

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MM say that in a perfect market, any combination of securities is as good as another. Let there be two
firms Firm U and Firm L

Firm U Unlevered

EU = VU (No debt)

Firm L Levered

EL = VL DL

Investment Choice

Strategy 1

Firm U: One percent of the shares cost 0.01VU and the returns are 0.01*Profit

Strategy 2

Purchase same fraction of both debt and equity of Firm L. The cost of investment would be 0.01(DL+EL) =
0.01VL. The return on Debt is Interest = 0.01*Interest whereas the return on Leveraged Equity is
0.01*(Profits-Interest). Thus, total return still remains 0.01*Profits

The law of one price says that if two strategies have the same return, then the initial investment must
also be the same. Thus we have,

0.01VU = 0.01VL
which implies,

VU = VL

Lets consider a situation where investors take more risk.

Strategy 3

Buy 1% of the outstanding shares of the levered firm

Investment = 0.01(VL-DL)

Return= 0.01(Profits-Interest)

Strategy 4

Borrow 0.01DL on your own and purchase 1% of the stock of your unlevered firm

Investment= Cost of purchasing shares - Borrowed funds

= 0.01*VU - 0.01*DL

= 0.01(VU DL)

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Return= Return on Shares Payment on borrowed funds

= 0.01*Profits 0.01*Interest

We again see that the same return has been yielded, which means that VL = VU

The risk appetite of the investor therefore does not affect the fact that the value of a firm is
independent of the security mix.

Law of Conservation of Value

This finding by MM translates to the fact that an asset retains its value even if it is split into n different
streams. This is called the law of conservation of Value.

This law applies to the mix of debt securities as well as to the choice between common and/or preferred
stock.

Throughout, we are assuming that borrowers and lenders can transact at the same risk free interest
rate. However, corporate debt is not risk free. If the company cannot make profits, then it forfeits its
debt obligations. Many individuals would like to assume this role where they have limited liability. Thus,
they'll be willing to pay a premium for levered shares if their supply was limited to below their demand.
However, given the multitude of companies, this is an unlikely situation.

Suppose theres a Company X. X is entirely funded by equity, having 1000 shares of Rs 10 each. The
valuation of the company stands at Rs. 10,000. The expected dividend per share is Rs. 1.5 and it is
expected to continue forever. This earning/dividend per share can actually turn out to be more or less
than Rs. 1.5.

Returns

Outcomes
Operating income 500 1000 1500 2000
(Assumed)
Earnings per share 0.5 1 1.5 2
Return on Shares (%) 5 10 15 20

X is considering raising a debt of Rs. 5000 @ 10% interest and repurchase 500 shares. Price per share is
Rs. 10, which makes the market value of the shares and the debt both stand at Rs. 5000. Interest @ 10%
equals Rs. 500

The outcomes can be:

Outcomes
Operating income 500 1000 1500 2000

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(assumed)
Interest 500 500 500 500
Equity Earnings 0 500 1000 1500
(operating income
interest)
Earnings per share 0 1 2 3
Return on Shares (%) 0 10 20 30

Since the expected dividend per share was Rs. 1.5, we see that the expected return on shares increases
to 20% if a fresh issue of debt for Rs. 5000 is made.

As we can see from the data in the tables, and from the graph which is made by plotting these data
points, the effect of leverage on earnings per share depends on the income of the company. Until Rs.
1000, the EPS is reduced by leverage, post which it increases with leverage. Thus, since you expect an
income of Rs. 1500, it makes sense to support the leveraging of the business. BUT, THIS IS NOT TRUE.
Your valuation of the company remains the same.

Why?

As a shareholder, you get a seemingly higher EPS with leveraged shares of X. However, even if you were
faced with an unleveraged X, you could have borrowed Rs. 10 at the market rate, and then bought 2
shares with Rs. 20. You invest only Rs. 10 of your own. Your return is then 2(EPS of unleveraged X)
Interest payment on the loan of Rs. 10. This will give you exactly the EPS of the leveraged company X.
Thus, even if X borrows Rs. 5,000 the valuation for the shareholders remains the same.

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Financial Economics

This proves MMs proposition.

Financial Risk and Expected Returns

The implications of MMs previous proposition (1) are the following:

Current Structure: All Proposed Structure: Equal

Equity Debt and Equity
Expected EPS 1.5 2
Price per Share 10 10
Expected return on share (%) 15 20

Leverage increases the Expected returns, but not the share price as the change in expected returns is
exactly offset by a change in the rate of discount applied to earnings.

Expected return on assets =

rA = (Expected operating income)/(Market value of all securities)

We know that the borrowing decision will not affect the numerator or the denominator, thus leaving rA
unchanged.

Expected return on a portfolio is the weighted average of expected returns on all individual holdings.

Expected return= (proportion in debt X expected return on debt) + (proportion in equity X expected
return on equity)

rA= (D/D+E)*rD + (E/D+E)*rE

this is also called the company cost of capital or the Weighted Average Cost of Capital (WACC)

We can use it to find an equation for rE

rE= rA + (rA rD)*D/E

This leads us directly to MMs Proposition (2).

It states that the expected rate of return on the common stock of a levered firm increases in proportion
to the debt-equity ratio expressed in market values; the rate of increase depends on the spread
between rA, the expected rate of return on portfolio of all the firms securities, and rD, the expected rate
of return on Debt.

Notice that this is exactly the same as the above equation, written in words.

Using the example of Company X, we see that before borrowing:

rE = rA = expected operating income / market vaue of all securities

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= 1500/10000

= 0.15 = 15%

After borrowing,

rA still remains 15%, but for rE we use the formula:

rE = 0.15 + (0.15-0.10)*(5000/5000)

= 0.20 = 20%

When the firm is levered, the equity investors want a higher return on their assets to compensate for
the higher risk.

MM Proposition 1: Financial leverage has no effect on shareholders wealth

MM Proposition 2: The rate of return they expect increases as the Debt-Equity ration increases

This may seem as a bit of a contradiction. You should understand that even though they enjoy a higher
rate of return on leveraged shares, it does not increase their wealth because as the rate of return is
increasing, so is the risk. And as the risk increases, the return they require to maintain their wealth
must increase, as it does.

Well analyze the risk with X shares.

If and when the Operating Income (OI) falls, the monetary loss borne by shareholders as a group
remains the same in a leveraged and an unleveraged company. So if the OI falls from Rs 1500 to Rs 500,
in an unleveraged company thats a loss of Rs. 1000 total, divided by 1000 shares to give a loss of Re 1
per share. In a leveraged firm, there are 500 shares, so the loss in now Rs. 2 per share. However, we can
look at the percentage spread. With 1000 shares, the same decline causes a reduction in return by 10%.
However, with just 500 shares and a equity value of (500*10=5000), a Rs. 1000 loss is a 20% reduction
on returns.

Thus, the effect of the leverage is to double the volatility of Xs shares. After refinancing, the beta of the
stock doubles.

How does Changing Capital Structure Affect Beta?

The risk of a firms cash flows is borne by both equity holders and debt holders. However, the share of
the latter is lower. The Beta of the portfolio is, similar to the returns, a weighted average of the Beta of
the individual components, i.e., the equity and the debt

A= portfolio= D(D/V) + E(E/V)

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After refinancing, the risk of the total package remains the same, but the individual betas rise. Thus,
borrowing creates financial leverage. Shareholders demand a correspondingly higher return because of
this financial risk of increased betas.

MM warns us that the shareholder value doesnt increase when returns to equity increases. It is merely a
reflection of greater risk.

MM's propositions have been graphed below.

The diagram shows that RE increases linearly with D/E. As D/E becomes really high, the return to equity
becomes less sensitive to the increase in debt. This is because the risk of the business is transferred from
stockholders to bond holders (the debt is taken tv purchasing essentially risk-free bonds)
In the absence of the MM propositions, a more traditional view was kept in place which insisted that the
objective of financial decisions was to minimize the weighted average cost of capital as opposed to
maximizing overall market value.
If MM's proposition 1 does not hold, then both these goals are fulfilled simultaneously unless the
Operating Income varies with the Capital Structure.

There are two Warnings against the traditional view:

Warning 1: The shareholders want an increase in the firm's value to become rich. They don't care as
much about owning a firm with a low WACC.

Warning 2: trying to minimize WACC leads to "logical short circuits". How? Imagine a scenario where an
attempt is made to reduce WACC by acquiring more debt because shareholders demand (and deserve) a
higher return. However, this is a fallacy because this ignores the fact that the shareholders will require a
higher rate (just enough to keep WACC constant) even if debt increases.

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The following diagram shows the Traditionalist view. Their argument rests on the assumption that
returns to shareholders does not increase (or increased very slowly) as the firm borrows more. If this is
true, then the WACC will fall as the D/E ratio increased because WACC is nothing but a weighted average
on the return to equity and return to debt. Traditionalist view says that initially, as debt increases the
return to equity will increase very slowly (lower than the increase MM predicted), but after a point,
when irresponsible firms excessively borrow, the return to equity must rise really fast (greater than
what was predicted by MM). Consequently, the WACC initially falls, reaches a minimum and then
increased with an increase in D/E.

The traditionalists provide two arguments for the intuition behind this theory.

1. The shareholders do not appreciate the risk initially, but later they demand high returns when the
debt becomes excessive
2. The second (better) argument is that the assumption of perfect markets that MM had applied might
not be true. If the shareholders get some other value added by buying levered shared then they might
not mind the extra risk.
Example: The corporate sector might have access to loans at a cheaper rate than consumer loans. So, a
person might want to buy shares so that he can indirectly get loans cheaply in-spite of the extra financial
risk. This happens because there are economies of scale in borrowing.
However, it is possible that these needs of the clientele have already been met.

This created the incentive of looking for unsatisfied clientele. We see new exotic securities coming up
everyday to satisfy these clients and sometimes to uncover a latent demand for that security.

Every time there is an imperfection in the markets, there is an opportunity to step in and fulfill a money-
making opportunity. This means that the clientele will become satisfied. The Government creates most
of these imperfections. For example, when the government laid down a limit on interest rates to be paid

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Financial Economics

on savings, it was done so that competition amongst savings institutions is limited. Then the smart
financial managers came up with the floating rate notes. This satisfies the new clientele and then MM's
proposition 1 is satisfied again.

Thus, if you ever find an unsatisfied clientele, do something right away, or capital markets will evolve
and steal it from you.

After Tax WACC

When the firm changes its mix if debt and equity securities, the risk and expected returns of securities
change but the company's overall WACC does not change. However, interest paid on debt is tax-
deductible which changes the cost of debt to rD(1-Tc) and the new WACC is

rD(1-Tc)*D/V + rE*E/V

Tc= Marginal Corporate Tax Rate

Thus, if companies are getting this tax advantage, then as Debt increased, the WACC falls.