Lecture 2 Spring 2019.pptx-FINA6278 LECT...
Lecture_2_Spring_2019.pptx-FINA6278 LECTURE 2 – CORPORATE LEVERAGE
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Lecture 2 Spring 2019.pptx-FINA6278 LECTURE 2 – CO...
Lecture_2_Spring_2019.pptx-FINA6278 LECTURE 2 – CORPORATE LEVERAGE
Lecture 2 Spring 2019.pptx-FINA6278...
Lecture_2_Spring_2019.pptx-FINA6278 LECTURE 2 – CORPORATE LEVERAGE
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Modigliani-Miller Irrelevance
Trade-off Theory
Pecking Order Theory
Empirical Evidence
In-class exercise

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How does a firm fund its operaons?
Retained earnings
Fixed payments; gets paid first
Uncertain payments; gets whatever is leſt aſter debt is paid

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Debt is an obligation
Firm must pay fixed interest payments to debt, otherwise in bankruptcy
Somemes debt contracts have covenants, or rules that firm must follow
Examples of posive debt covenants (things a firm
Maintain sasfactory accounng records that conform to GAAP
Maintain life insurance on key employees and execuves
Maintain a certain minimum amount of net working capital
Maintain a minimum interest coverage rao
Examples of negave debt covenants (things a firm must
Sell accounts receivable to generate cash
Issue addional debt that is not subordinate to current debt
Engage in merger without approval of debtholders

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Equity obligations not as
Equity owners have an ownership stake in the company
Corporate law requires execuves and board members to serve a fiduciary duty
to shareholders (act in their best interest)
But raising equity capital is generally not as operaonally restricve as debt
For example, there is no minimum net working capital or interest coverage requirement to
raise equity
While equity holders can vote on mergers, generally officers and directors own a controlling
Can have dual-class shares if control is an issue

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So which one should a firm pick?
If a firm wants to fund operaons, and it does not have or does not
want to use retained earnings, should it raise debt or equity? Does it
Does using one versus the other make the firm more risky?

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Some starting assumptions
(Perfect Capital Markets)
No taxes
Informaon set is same for managers and all investors
No transacon costs
Investors and markets are raonal (act to maximize their profit)
Firm’s level of investment is fixed
No costs of bankruptcy or restructuring
Managers act in the best interest of shareholders

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Perfect Capital Markets Example
A firm has assets which generate annual returns of $10 in perpetuity and require
no reinvestment of profits. The required rate of return on these assets is 10%.
The firm does not have any debt financing.
What is the value of the firm?
What would the value of the firm be were it to raise debt worth $50 and
repurchase $50 of equity? Let’s assume a market interest rate of 7%.

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