The Key Questions of Corporate Finance

• Valuation: How do we distinguish between good investment projects and bad ones?

• Financing: How should we finance the investment projects we choose to undertake?

Financing Policy

1. Real investment policies imply funding needs.

2. We have tools to forecast the funding needs to follow a given real investment policy

3. But what is the best source of funds? Internal funds (i.e., cash)?

Debt (i.e., borrowing)? Equity (i.e., issuing stock)?

Moreover, different kinds of ... internal funds (e.g., cash reserves vs. cutting dividends) debt (e.g., Banks vs. Bonds) equity (e.g., VC vs. IPO)

• Capital Structure • Capital Structure represents the mix of claims

against a firm’s assets and free cash flow • Some characteristics of financial claims:

– Payoff structure (e.g. fixed promised payment) – Priority (debt paid before equity) – Restrictive Covenants – Voting rights Options (convertible securities, call

provisions, etc)

• We focus on leverage (debt vs. equity) and how it can affect firm

• Choosing an Optimal Capital Structure

• Is there an “optimal” capital structure, i.e., an optimal mix between debt and equity?

• More generally, can you add value on the RHS of the BS by following a good financial policy?

• If yes, does the optimal financial policy depend on the firm’s operations (Real Investment policy), and how?

Table 1: Pattern of security issue over 1997-2007.• A balanced panel of 585 manufacturing firms from “Capitaline Plus” data base is used. The sample

period is 1995 to 2007. An equity issue is an event of net equity being positive while debt issue is captured as net debt being positive.

Year Equity Issue Debt Issue

1997 24.3% 62.8%

1998 20.5% 61.0%

1999 16.5% 57.2%

2000 16.2% 57.5%

2001 12.9% 53.6%

2002 11.1% 45.3%

2003 9.8% 45.6%

2004 14.2% 44.3%

2005 16.5% 54.4%

2006 21.8% 52.6%

2007 24.3% 56.5%

Over all 17.1% 53.7%

Table 2: Pattern of security issue over 1997-2007.

YearPure Equity Pure Debt Joint Issue None

1997 0.08 0.46 0.17 0.30

1998 0.07 0.47 0.14 0.32

1999 0.06 0.47 0.10 0.36

2000 0.06 0.47 0.10 0.36

2001 0.05 0.46 0.07 0.41

2002 0.06 0.40 0.05 0.49

2003 0.06 0.41 0.04 0.49

2004 0.08 0.39 0.06 0.47

2005 0.07 0.45 0.09 0.38

2006 0.09 0.40 0.13 0.38

2007 0.08 0.40 0.16 0.35

Over all 0.07 0.44 0.10 0.39

Companies and Industries Vary in Their Capital Structures

Industry Debt Ratio* (%) Electric and Gas 43.2 Food Production 22.9 Paper and Plastic 30.4 Equipment 19.1 Retailers 21.7 Chemicals 17.3 Computer Software 3.5 Average over all industries 21.5%

• * Debt Ratio = Ratio of book value of debt to the sum of the book value of debt plus the market value of equity.

Returns

Average Annual Rate Average rates of return on Treasury bills, government bonds, corporate bonds, and common stocks, 1926-1997 (figures in percent per year)

Average Risk Premium

Portfolio Nominal Real (over T-Bills)

Treasury bills 3.8 0.7 0.0 Government bonds 5.6 2.6 1.8 Corporate bonds 6.1 3.0 2.3 Common stocks (S&P 500) 13.0 9.7 9.2 Small-firm common stocks 17.7 14.2 13.9

Source: Ibbotson Associates, Inc., 1998 Yearbook (Brealey & Myers p.155)

Plan of Attack

1. Modigliani-Miller Theorem:

Capital Structure is irrelevant

2. What’s missing from the M-M view?

• Taxes

• Costs of financial distress

• Other factors

M-M’s “Irrelevance” Theorem MM Theorem (without taxes for now).

Financing decisions are irrelevant for firm value. In particular, the choice of capital structure is irrelevant.

• Proof:

From Finance Theory,

1. Purely financial transactions do not change the total cash flows and are therefore zero NPV investments.

2. With no arbitrage opportunities, they cannot change the total price

Thus, they neither increase nor decrease firm value.

• Q.E.D.

Get the BM example

Indirect cost : Debt Overhang

Capital Structure – 3