Index
Lecture 1: Capital Structure 2
Lecture 2: Agency Conflicts 6
Lecture 3: Pay Out Policies 13
Lecture 4: Valuation 17
Lecture 5: Long-term Financing 22
Lecture 6: Net Working Capital (Tutorial 6) 24
Lecture 7: Corporate Governance 27
Lecture 8: Corporate Finance in Emerging Economies 29
Lecture 9: Valuation in Emerging Economies 33
,Lecture 1: Capital Structure
The financial position of a company is defined by two equal sides:
• Assets: what the enterprise owns (the resources with which it will create value for customers)
o Goal: maximising earnings, cash flows and returns
• Equity and liabilities: obligations the entity has towards shareholders and third parties (the sources of
financing for assets)
o Goal: minimising cost of capital
Equity vs. debt financing
• Capital structure: the relative proportions of debt, equity and other securities that a firm has outstanding
• Leverage: debt to equity ratio
• Most relevant differences between debt and equity:
o Debt claims have a higher seniority (interest is paid before dividend)
o Equity holders are the owners of the firm; they have voting rights and are residual claimants
o Equity holders are secured by limited liability
•
Financing a firm with equity (example)
• You are considering an investment opportunity
o Initial investment = $800 this year
o Project will generate cash flows of either $1400 or $900 next year, depending on whether the
economy strong or weak
o Both scenarios are equally likely
o The project cash flows depend on the overall economy and thus contain market risk
o As a result, you demand a 10% risk premium over the current risk-free interest rate of 5% to invest
in this project
• What is the NPV of this investment opportunity?
• If you finance this project using only equity, how much would you be willing to pay for the project
o
o After paying the investment cost of $800, assume you can raise $1000 by selling equity in the firm
o You can keep the remaining $200, the NPV of the project, as a profit
• Unlevered equity – equity in a firm with no debt
o Because there is no debt, the cash flows of the unlevered equity are equal to those of the project
o Shareholder’s returns are either 40% or – 10%
o The expected return on the unlevered equity is: ½ (40%) + ½ (– 10%) = 15%
o Because the cost of capital of the project is 15%, shareholders are earning an appropriate return for
the risk they are taking
2
, • Levered equity – equity in a firm that also has debt outstanding
o Suppose you decide to borrow $500 initially, in addition to selling equity
o As the project’s cash flow will always be enough to repay the debt, the debt is risk free and you can
borrow at the risk-free interest rate of 5%
o You will owe the debt holders: $500 x 1.05 = $525 in one year
o Given the firm’s $525 debt obligation, what will shareholders receive?
§ Strong economy: $1400 – $525 = $875
§ Weak economy: $900 – $525 = $375
o What price E should the levered equity sell for?
§ The cash flows of the debt and equity sum to the cash flows of the project
§ The Law of One Price suggests that the combined values of debt and equity must be $1000
§ Therefore, if the value of the debt is $500, the value of the levered equity must be $500
§ E = $1000 – $500 = $500
o Which is the best capital structure choice for the entrepreneur?
§ Because the cash flows of levered equity are smaller than those of unlevered equity, levered
equity will sell for a lower price ($500 versus $1000)
§ However, you are not worse off. You will still raise a total of $1000 by issuing both debt and
levered equity
§ Consequently, you would be indifferent between these two choices for the firm’s capital
structure
§ The Law of One Price implies that leverage will not affect the total value of the firm
• Instead, it merely changes the allocation of cash flows between debt and equity,
without altering the total cash flows of the firm
The effect of leverage on risk and return
• Leverage increases the risk of the equity of a firm
• Therefore, it is inappropriate to discount the cash flows of levered equity at the same discount rate of 15%
that you used for unlevered equity
• Investors in levered equity will require a higher return to compensate for the increased risk
o The returns to equity holders are very different with and without leverage
o Unlevered equity has a return of either 40% or –10%, for an expected return of 15%
o Levered equity has higher risk, with a return of either 75% or –25%
o compensate for this risk, levered equity holders receive a higher expected return of 25%
• The relationship between risk and return can be evaluated more formally
o The sensitivity of each security’s return to the systematic risk of the economy
o Because the debt’s return bears no systematic risk, its risk premium is zero
o In this case, the levered equity has twice the systematic risk of unlevered equity and thus has twice
the risk premium
o In the case of perfect capital markets, if the firm is 100% equity financed, the equity holders will
require a 15% expected return
o If the firm is financed 50% debt and 50% equity, the debt holders will receive a return of 5%, while
the levered equity holders will require an expected return of 25% (because of their increased risk)
3
, • Leverage increases the risk of equity even when there is no risk that the firm will default
• Thus, while debt may be cheaper, its use raises the cost of capital for equity
• Considering both sources of capital together, the firm’s average cost of capital with leverage is the same as
for the unlevered firm
Lessons from Miller and Modigliani
• M&M argued that with perfect capital markets, the total value of a firm should not depend on its capital
structure
• They reasoned that the firm’s total cash flows should equal the cash flows of the project, and therefore have
the same present value
• MM showed that this result holds more generally under a set of conditions referred to as perfect capital
markets:
o Investors and firms can trade the same set of securities at competitive market prices equal to the
present value of their future cash flows
o There are no taxes, transaction costs, or issuance costs associated with security trading
o A firm’s financing decisions do not change the cash flows generated by its investments nor do they
reveal new information about them
• MM and the Law of One Price
o Under conditions of perfect capital markets, the total cash flow paid out to all of a firm’s security
holders is equal to the total cash flow generated by the firm’s assets
o Therefore, by the Law of One Price, the firm’s securities and its assets must have the same total
market value
Homemade leverage
• Homemade leverage: investors use leverage in their own portfolio to adjust the leverage choice made by
the firm
• MM demonstrated that if investors would prefer an alternative capital structure to the one the firm has
chosen, investors can borrow or lend on their own and achieve the same result
• Assume you use no leverage and create an all-equity firm
o An investor who would prefer to hold levered equity can do so by using leverage in his own portfolio
o Assume the cash flows of the unlevered equity serve as collateral for the margin loan (at the risk-
free rate of 5%)
o By using homemade leverage, the investor has replicated the payoffs to the levered equity for a cost
of $500
o By the Law of One Price, the value of levered equity must also be $500
• Now assume you use debt, but the investor would prefer to hold unlevered equity (replicating unlevered
equity by holding debt and equity)
o The investor can re-create the payoffs of unlevered equity by buying both the debt and the equity of
the firm
o Combining the cash flows of the two securities produces cash flows identical to unlevered equity, for
a total cost of $1000
• In each case, your choice of capital structure does not affect the opportunities available to investors
o Investors can alter the leverage choice of the firm to suit their personal tastes either by adding more
leverage or reducing leverage
o With perfect capital markets, different choices of capital structure offer no benefit to investors and
does not affect the value of the firm
4
Lecture 1: Capital Structure 2
Lecture 2: Agency Conflicts 6
Lecture 3: Pay Out Policies 13
Lecture 4: Valuation 17
Lecture 5: Long-term Financing 22
Lecture 6: Net Working Capital (Tutorial 6) 24
Lecture 7: Corporate Governance 27
Lecture 8: Corporate Finance in Emerging Economies 29
Lecture 9: Valuation in Emerging Economies 33
,Lecture 1: Capital Structure
The financial position of a company is defined by two equal sides:
• Assets: what the enterprise owns (the resources with which it will create value for customers)
o Goal: maximising earnings, cash flows and returns
• Equity and liabilities: obligations the entity has towards shareholders and third parties (the sources of
financing for assets)
o Goal: minimising cost of capital
Equity vs. debt financing
• Capital structure: the relative proportions of debt, equity and other securities that a firm has outstanding
• Leverage: debt to equity ratio
• Most relevant differences between debt and equity:
o Debt claims have a higher seniority (interest is paid before dividend)
o Equity holders are the owners of the firm; they have voting rights and are residual claimants
o Equity holders are secured by limited liability
•
Financing a firm with equity (example)
• You are considering an investment opportunity
o Initial investment = $800 this year
o Project will generate cash flows of either $1400 or $900 next year, depending on whether the
economy strong or weak
o Both scenarios are equally likely
o The project cash flows depend on the overall economy and thus contain market risk
o As a result, you demand a 10% risk premium over the current risk-free interest rate of 5% to invest
in this project
• What is the NPV of this investment opportunity?
• If you finance this project using only equity, how much would you be willing to pay for the project
o
o After paying the investment cost of $800, assume you can raise $1000 by selling equity in the firm
o You can keep the remaining $200, the NPV of the project, as a profit
• Unlevered equity – equity in a firm with no debt
o Because there is no debt, the cash flows of the unlevered equity are equal to those of the project
o Shareholder’s returns are either 40% or – 10%
o The expected return on the unlevered equity is: ½ (40%) + ½ (– 10%) = 15%
o Because the cost of capital of the project is 15%, shareholders are earning an appropriate return for
the risk they are taking
2
, • Levered equity – equity in a firm that also has debt outstanding
o Suppose you decide to borrow $500 initially, in addition to selling equity
o As the project’s cash flow will always be enough to repay the debt, the debt is risk free and you can
borrow at the risk-free interest rate of 5%
o You will owe the debt holders: $500 x 1.05 = $525 in one year
o Given the firm’s $525 debt obligation, what will shareholders receive?
§ Strong economy: $1400 – $525 = $875
§ Weak economy: $900 – $525 = $375
o What price E should the levered equity sell for?
§ The cash flows of the debt and equity sum to the cash flows of the project
§ The Law of One Price suggests that the combined values of debt and equity must be $1000
§ Therefore, if the value of the debt is $500, the value of the levered equity must be $500
§ E = $1000 – $500 = $500
o Which is the best capital structure choice for the entrepreneur?
§ Because the cash flows of levered equity are smaller than those of unlevered equity, levered
equity will sell for a lower price ($500 versus $1000)
§ However, you are not worse off. You will still raise a total of $1000 by issuing both debt and
levered equity
§ Consequently, you would be indifferent between these two choices for the firm’s capital
structure
§ The Law of One Price implies that leverage will not affect the total value of the firm
• Instead, it merely changes the allocation of cash flows between debt and equity,
without altering the total cash flows of the firm
The effect of leverage on risk and return
• Leverage increases the risk of the equity of a firm
• Therefore, it is inappropriate to discount the cash flows of levered equity at the same discount rate of 15%
that you used for unlevered equity
• Investors in levered equity will require a higher return to compensate for the increased risk
o The returns to equity holders are very different with and without leverage
o Unlevered equity has a return of either 40% or –10%, for an expected return of 15%
o Levered equity has higher risk, with a return of either 75% or –25%
o compensate for this risk, levered equity holders receive a higher expected return of 25%
• The relationship between risk and return can be evaluated more formally
o The sensitivity of each security’s return to the systematic risk of the economy
o Because the debt’s return bears no systematic risk, its risk premium is zero
o In this case, the levered equity has twice the systematic risk of unlevered equity and thus has twice
the risk premium
o In the case of perfect capital markets, if the firm is 100% equity financed, the equity holders will
require a 15% expected return
o If the firm is financed 50% debt and 50% equity, the debt holders will receive a return of 5%, while
the levered equity holders will require an expected return of 25% (because of their increased risk)
3
, • Leverage increases the risk of equity even when there is no risk that the firm will default
• Thus, while debt may be cheaper, its use raises the cost of capital for equity
• Considering both sources of capital together, the firm’s average cost of capital with leverage is the same as
for the unlevered firm
Lessons from Miller and Modigliani
• M&M argued that with perfect capital markets, the total value of a firm should not depend on its capital
structure
• They reasoned that the firm’s total cash flows should equal the cash flows of the project, and therefore have
the same present value
• MM showed that this result holds more generally under a set of conditions referred to as perfect capital
markets:
o Investors and firms can trade the same set of securities at competitive market prices equal to the
present value of their future cash flows
o There are no taxes, transaction costs, or issuance costs associated with security trading
o A firm’s financing decisions do not change the cash flows generated by its investments nor do they
reveal new information about them
• MM and the Law of One Price
o Under conditions of perfect capital markets, the total cash flow paid out to all of a firm’s security
holders is equal to the total cash flow generated by the firm’s assets
o Therefore, by the Law of One Price, the firm’s securities and its assets must have the same total
market value
Homemade leverage
• Homemade leverage: investors use leverage in their own portfolio to adjust the leverage choice made by
the firm
• MM demonstrated that if investors would prefer an alternative capital structure to the one the firm has
chosen, investors can borrow or lend on their own and achieve the same result
• Assume you use no leverage and create an all-equity firm
o An investor who would prefer to hold levered equity can do so by using leverage in his own portfolio
o Assume the cash flows of the unlevered equity serve as collateral for the margin loan (at the risk-
free rate of 5%)
o By using homemade leverage, the investor has replicated the payoffs to the levered equity for a cost
of $500
o By the Law of One Price, the value of levered equity must also be $500
• Now assume you use debt, but the investor would prefer to hold unlevered equity (replicating unlevered
equity by holding debt and equity)
o The investor can re-create the payoffs of unlevered equity by buying both the debt and the equity of
the firm
o Combining the cash flows of the two securities produces cash flows identical to unlevered equity, for
a total cost of $1000
• In each case, your choice of capital structure does not affect the opportunities available to investors
o Investors can alter the leverage choice of the firm to suit their personal tastes either by adding more
leverage or reducing leverage
o With perfect capital markets, different choices of capital structure offer no benefit to investors and
does not affect the value of the firm
4
