|
|
|
Lecture 2 Spring 2019.pptx
Lecture_2_Spring_2019.pptx
Showing 1-8 out of 49
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
Page 1
FINA6278
LECTURE 2 – CORPORATE LEVERAGE
Page 2
Outline
Modigliani-Miller Irrelevance
Trade-off Theory
Pecking Order Theory
Empirical Evidence
In-class exercise
Page 3
Introduction
How does a firm fund its operaons?
Retained earnings
Debt
Equity
Debt
Fixed payments; gets paid first
Equity
Uncertain payments; gets whatever is leſt aſter debt is paid
Page 4
Debt is an obligation
Firm must pay fixed interest payments to debt, otherwise in bankruptcy
Somemes debt contracts have covenants, or rules that firm must follow
Examples of posive debt covenants (things a firm
must
do):
Maintain sasfactory accounng records that conform to GAAP
Maintain life insurance on key employees and execuves
Maintain a certain minimum amount of net working capital
Maintain a minimum interest coverage rao
Examples of negave debt covenants (things a firm must
not
do):
Sell accounts receivable to generate cash
Issue addional debt that is not subordinate to current debt
Engage in merger without approval of debtholders
Page 5
Equity obligations not as
restrictive
Equity owners have an ownership stake in the company
Corporate law requires execuves and board members to serve a fiduciary duty
to shareholders (act in their best interest)
But raising equity capital is generally not as operaonally restricve as debt
capital
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
share
Can have dual-class shares if control is an issue
Page 6
So which one should a firm pick?
If a firm wants to fund operaons, and it does not have or does not
want to use retained earnings, should it raise debt or equity? Does it
maer?
Does using one versus the other make the firm more risky?
Page 7
Some starting assumptions
(Perfect Capital Markets)
No taxes
Informaon set is same for managers and all investors
No transacon costs
Investors and markets are raonal (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
Page 8
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%.
Ace your assessments! Get Better Grades
Browse thousands of Study Materials & Solutions from your Favorite Schools
George Washington Univers...
George_Washington_University
School:
Financial_Theory_and_Research
Course:
Great resource for chem class. Had all the past labs and assignments
Leland P.
Santa Clara University
Introducing Study Plan
Using AI Tools to Help you understand and remember your course concepts better and faster than any other resource.
Find the best videos to learn every concept in that course from Youtube and Tiktok without searching.
Save All Relavent Videos & Materials and access anytime and anywhere
Prepare Smart and Guarantee better grades
Know more
Students also viewed documents
lab 18.docx
lab_18.docx
Course
Course
3
Module5QuizSTA2023.d...
Module5QuizSTA2023.docx.docx
Course
Course
10
Week 7 Test Math302....
Week_7_Test_Math302.docx.docx
Course
Course
30
Chapter 1 Assigment ...
Chapter_1_Assigment_Questions.docx.docx
Course
Course
5
Week 4 tests.docx.do...
Week_4_tests.docx.docx
Course
Course
23
Week 6 tests.docx.do...
Week_6_tests.docx.docx
Course
Course
106
