Summary Advanced Corporate
Finance
Part 1 Back to the Basics
Week 1 – Lecture 1&2&3
Finance sources: Internal and External capital.
1. Internal capital: Retained earnings – profts not payed back to shareholders but used to fnance
investment, current expenses etc.
2. External capital:
a. Debt: Debtholders have a contract specifying that their claim must be paid in full before
the frm can make payments to the eqouity holders, they dontt have votng rights. Debt is
a senior claim to eqouity. So if a company goes bankruptcy: frst pay your debtholders
and the lefover money is for the eqouity holders.
b. Eqouity : eqouity holders receive a dividend only afer the debtholders claims are satsfed
and they have the right to vote at the general meetng of shareholders.
Two forms of leverage:
Debt Debt
1. Academic leverage: or Leverage can change because of: debt is
Equity Total Assets
issued (more leverage) or paid back (leverage goes down). Or eqouity is issued or paid back.
Debt
2. Industry leverage: this is the most common measure of leverage. It is usually
EBIT
indicated with 3x, 4x … (3x means for example that it will take (on average) 3 years to pay back
your debt).
Taking an easy framework, Finance wontt mater (so the rato between debt & eqouity doesntt mater –
so: your frm will not become more valuable by using more debt or eqouity).
Assumptions of M&M (Modigliani – Millerl
1. Perfect fnancial markets:
• Compettve: Individuals and frms are price-takers
• Frictonless: No transacton costs, etc.
• All agents are ratonal
2. All agents have the same informaton
3. A frmts cash-flows do not depend on its fnancial policy (e.g. no bankruptcy costs – because
otherwise the lawyer can manipulate their pay-of to maximize her own earnings)
4. No taxes
These assumptons are not the case in real-life (you always have to pay taxes etc.) SO: Finance does
mater! If you life in a perfect world (the assumptons hold), Finance doesntt mater, but the investment
maters. So, the way you fnance your proeectiinvestment will maters if you life in a real world!
The original propositions:
, • MM-Proposition I (MM 1958): A frmts total market value is independent of its capital structure
(so: capital structure doesntt mater) SO: Vl = Vu
The value of a frm is the Present Discounted value of Future Cash Flows (CF). When a frm issues debt &
eqouity securites, it splits its CF into a safe stream (to bondholders) and a risky stream (to stockholders)
What maters is how much money (Cash flows) the company is able to generate and to pay. So the size
of the cash flows maters, not the rato between eqouity and debt – the way we fnance it wontt make the
CF bigger (or smaller) (CF = debt + eqouity). So frms cannot change the total value of their securites by
splitting CFts into two diferent streams. But: Firm value is determined by the real assets.
VU = VE = (EBIT) i rU These two eqouatons will gave the same answer
VL = D + E = [INT + (EBIT – Int)] i rU
VU = Value unlevered. Vl = Value levered. VE = Value Eqouity.
• MM-Proposition II (MM 1958): A frmts cost of eqouity increases with its debt-eqouity rato
D E
The Firm Weighted Average Cost of Capital is: WACC = rd + r
(D+ E) ( D+ E) E
D
r E=( WACC−r d ) +WACC
E
D
If WACC >r d r E is increasing with
E
Intuition: increasing Debt makes eqouity riskier, increasing the expected returns investors demand
Debts generates risk (so: higher reqouired return), there are two types of risk:
1. Business risk: Typical enterprise risk - this depends on the type of investment you undertake (if
you want to become the new Steve Jobs (Apple), your business risk is high.
Business risk = Financial risk in an all eqouity fnanced frm.
Business risk < fnancial risk, when a frm is partly debt fnanced
2. Financial risk: Risk of the eqouity investment. It is the additonal risk placed on the common
stockholders as a result of the decision to fnance with debt. Leverage increase shareholder risk
and the return on eqouity (to compensate for the higher risk) (
β L =β U 1+
D
E )
The beta changed because it is a measure of risk (higher beta more risk)
Βl > βU = Always!
Common mistake propositon II: when you have more debt, you have higher returns wrong: dontt
forget the risk!
• Dividend Irrelevance (MM 1961): A frmts total market value is independent of its dividend
policy (= pay out your dividend or have retained earnings)
,Investor Indiference (Stglitz 1969): Individual investors (the ones who are supposed to buy shares from
a company) are indiferent to all frmst fnancial policies (so they invest in companies which make
profts) – we dontt care about the rato debt & eqouity.
The morale of this propositon: managers should not care about the risk preferences of the investor. We
eust need that investors have the ability to borrow and lend for their own account (= homemade
leverage: borrowing at the same rate as frms – because we assume all informaton is available) so that
they can “undo” any changes in frmts capital structure. So as a manager: care about your investments,
not how to finance them!
Clientèless Theory (or Financial Marketng Theory): diferent investors prefer diferent consumptons
streams, they may prefer diferent fnancial assets and fnancial policy serves these diferent clienteles.
Example: All-eqouity frms might fail to exploit investorst demands for safe and risky assets. It may be
beter to issue both debt and eqouity to allow investors to focus on their preferred asset mix
Intuiton from MM: Investorts preferences are over consumpton, not fnancial assets. They can
sliceidiceicombineire-trade the frmts securites. If investors can undertake the same transactons as
frms, they will not pay a premium for frms to undertake them on their behalf no value in fnancial
marketng.
Because we dontt care about the rato debt & eqouity (any combinaton of securites is as good as any
other), two frms with the same operatng income and who difer only in capital structure:
- Unlevered frm: VU = EU
- Levered frm: EL = VL – DL
EL = Value of eqouity
VL = (Total) value of the company
If you borrow money on your own account = homemade leverage (so go to a bank and borrow money,
you can do this for example to invest it aferwards in a company without leverage).
M&M is not a literal statement about the world but it helps you to avoid frst-order mistakes, their most
basic message is:
- Value is created only (i.e. in practce mostly) by operatng assets, i.e. on Lef and Side of the
Balance Sheet
- A frmts fnancial policy should be (mostly) a means to support the operatng policy, not
(generally) an end in itself
Debt and taxes:
Corporatons pay (usually) less taxes on debt than eqouity (because debt is subsidized), this is important
because:
- Efficiency: introducton of taxes and subsidies may distort otherwise socially optmal decisions
- Financial stability: companies may issue “too much” debt, putting pressure on the banking
system
Because interest is tax-free, corporatons are more likely to issue more debt (too much) – this can lead
to a fnancial crisis.
Finance stll does not have a clear idea of the impact of taxes on debt.
, M&M propositions with taxes: By using debt – you have higher CFts because of the debt (you pay more
tax on eqouity and no tax on interest, so interest is tax-free) CF = debt + eqouity (net income)
Debt∗r d∗Tax rate
PV of Tax Shield= = Debt∗Tax rate
rd
The frm value of a levered frm = Value of all eqouity frm + PV tax shield.
The all eqouity value = cash flow debt + eqouity (unlevered frm) i r u.
Paper “Capital Structure and Taxes: What happens when you (alsol subsidize equity?”
The paper is about Belgium, where the government decided to subsidize eqouity. The NID (Notonal
Interest Deducton) is an explicit eqouity deducton (introduced in Belgium in 2006). The obeectve was to
reduce the tax-driven distortons that favour the use of debt fnancing. The NID allows frms to deduct
from their taxable income a notonal charge eqoual to the product of the book value of eqouity * a
benchmark interest rate based on historical long-term government bonds (so it means that a X amount
of your eqouity is tax-free). Your CF at the end = net income + NID). So NID is for ex. 5% of your eqouity.
When you have a levered frm, debt is stll subsidized as well! (so not only NID is available). Net income
will be the same for the levered frm as unlevered frm,
because NID is calculated over you eqouity (eqouity is
lower when you have debt). See example:
NID was only introduced in Belgium (in 2006) = threated
country, and The Netherlands, Germany, Luxembourg
and France are the “control countries” – they are
unchanged. This empirical strategy is called diference
in diference analysis.
Data: (eqouaton)
y ikt =α +θ NID kt +d t + d k +Ψ X ikt + ε ikt
The dummy variable: θ NID kt will take value 1 if your
company is located in Belgium afer 2006 and take value 0 if itts about the control countries. (only
important variable for us)
Data: they observed the countries before and afer the treatment of the NID (2002-2009). They had on
average 6 observatons per type frm (diferent frms) (sample more than 1 million, 235,000 uniqoue
frms).
This fgure is only related to Belgium frms. The vertcal axes:
Eqouity over total assets in %. orizontal axes: years (2005 is the
last year before the reform). As you can see they already started
to use more eqouity before the NID was introduced (but the
biggest increase was afer 2005).
The fgure below (frm level analysis eqouity rato = Belgium –
control countries):
doted line is the
Finance
Part 1 Back to the Basics
Week 1 – Lecture 1&2&3
Finance sources: Internal and External capital.
1. Internal capital: Retained earnings – profts not payed back to shareholders but used to fnance
investment, current expenses etc.
2. External capital:
a. Debt: Debtholders have a contract specifying that their claim must be paid in full before
the frm can make payments to the eqouity holders, they dontt have votng rights. Debt is
a senior claim to eqouity. So if a company goes bankruptcy: frst pay your debtholders
and the lefover money is for the eqouity holders.
b. Eqouity : eqouity holders receive a dividend only afer the debtholders claims are satsfed
and they have the right to vote at the general meetng of shareholders.
Two forms of leverage:
Debt Debt
1. Academic leverage: or Leverage can change because of: debt is
Equity Total Assets
issued (more leverage) or paid back (leverage goes down). Or eqouity is issued or paid back.
Debt
2. Industry leverage: this is the most common measure of leverage. It is usually
EBIT
indicated with 3x, 4x … (3x means for example that it will take (on average) 3 years to pay back
your debt).
Taking an easy framework, Finance wontt mater (so the rato between debt & eqouity doesntt mater –
so: your frm will not become more valuable by using more debt or eqouity).
Assumptions of M&M (Modigliani – Millerl
1. Perfect fnancial markets:
• Compettve: Individuals and frms are price-takers
• Frictonless: No transacton costs, etc.
• All agents are ratonal
2. All agents have the same informaton
3. A frmts cash-flows do not depend on its fnancial policy (e.g. no bankruptcy costs – because
otherwise the lawyer can manipulate their pay-of to maximize her own earnings)
4. No taxes
These assumptons are not the case in real-life (you always have to pay taxes etc.) SO: Finance does
mater! If you life in a perfect world (the assumptons hold), Finance doesntt mater, but the investment
maters. So, the way you fnance your proeectiinvestment will maters if you life in a real world!
The original propositions:
, • MM-Proposition I (MM 1958): A frmts total market value is independent of its capital structure
(so: capital structure doesntt mater) SO: Vl = Vu
The value of a frm is the Present Discounted value of Future Cash Flows (CF). When a frm issues debt &
eqouity securites, it splits its CF into a safe stream (to bondholders) and a risky stream (to stockholders)
What maters is how much money (Cash flows) the company is able to generate and to pay. So the size
of the cash flows maters, not the rato between eqouity and debt – the way we fnance it wontt make the
CF bigger (or smaller) (CF = debt + eqouity). So frms cannot change the total value of their securites by
splitting CFts into two diferent streams. But: Firm value is determined by the real assets.
VU = VE = (EBIT) i rU These two eqouatons will gave the same answer
VL = D + E = [INT + (EBIT – Int)] i rU
VU = Value unlevered. Vl = Value levered. VE = Value Eqouity.
• MM-Proposition II (MM 1958): A frmts cost of eqouity increases with its debt-eqouity rato
D E
The Firm Weighted Average Cost of Capital is: WACC = rd + r
(D+ E) ( D+ E) E
D
r E=( WACC−r d ) +WACC
E
D
If WACC >r d r E is increasing with
E
Intuition: increasing Debt makes eqouity riskier, increasing the expected returns investors demand
Debts generates risk (so: higher reqouired return), there are two types of risk:
1. Business risk: Typical enterprise risk - this depends on the type of investment you undertake (if
you want to become the new Steve Jobs (Apple), your business risk is high.
Business risk = Financial risk in an all eqouity fnanced frm.
Business risk < fnancial risk, when a frm is partly debt fnanced
2. Financial risk: Risk of the eqouity investment. It is the additonal risk placed on the common
stockholders as a result of the decision to fnance with debt. Leverage increase shareholder risk
and the return on eqouity (to compensate for the higher risk) (
β L =β U 1+
D
E )
The beta changed because it is a measure of risk (higher beta more risk)
Βl > βU = Always!
Common mistake propositon II: when you have more debt, you have higher returns wrong: dontt
forget the risk!
• Dividend Irrelevance (MM 1961): A frmts total market value is independent of its dividend
policy (= pay out your dividend or have retained earnings)
,Investor Indiference (Stglitz 1969): Individual investors (the ones who are supposed to buy shares from
a company) are indiferent to all frmst fnancial policies (so they invest in companies which make
profts) – we dontt care about the rato debt & eqouity.
The morale of this propositon: managers should not care about the risk preferences of the investor. We
eust need that investors have the ability to borrow and lend for their own account (= homemade
leverage: borrowing at the same rate as frms – because we assume all informaton is available) so that
they can “undo” any changes in frmts capital structure. So as a manager: care about your investments,
not how to finance them!
Clientèless Theory (or Financial Marketng Theory): diferent investors prefer diferent consumptons
streams, they may prefer diferent fnancial assets and fnancial policy serves these diferent clienteles.
Example: All-eqouity frms might fail to exploit investorst demands for safe and risky assets. It may be
beter to issue both debt and eqouity to allow investors to focus on their preferred asset mix
Intuiton from MM: Investorts preferences are over consumpton, not fnancial assets. They can
sliceidiceicombineire-trade the frmts securites. If investors can undertake the same transactons as
frms, they will not pay a premium for frms to undertake them on their behalf no value in fnancial
marketng.
Because we dontt care about the rato debt & eqouity (any combinaton of securites is as good as any
other), two frms with the same operatng income and who difer only in capital structure:
- Unlevered frm: VU = EU
- Levered frm: EL = VL – DL
EL = Value of eqouity
VL = (Total) value of the company
If you borrow money on your own account = homemade leverage (so go to a bank and borrow money,
you can do this for example to invest it aferwards in a company without leverage).
M&M is not a literal statement about the world but it helps you to avoid frst-order mistakes, their most
basic message is:
- Value is created only (i.e. in practce mostly) by operatng assets, i.e. on Lef and Side of the
Balance Sheet
- A frmts fnancial policy should be (mostly) a means to support the operatng policy, not
(generally) an end in itself
Debt and taxes:
Corporatons pay (usually) less taxes on debt than eqouity (because debt is subsidized), this is important
because:
- Efficiency: introducton of taxes and subsidies may distort otherwise socially optmal decisions
- Financial stability: companies may issue “too much” debt, putting pressure on the banking
system
Because interest is tax-free, corporatons are more likely to issue more debt (too much) – this can lead
to a fnancial crisis.
Finance stll does not have a clear idea of the impact of taxes on debt.
, M&M propositions with taxes: By using debt – you have higher CFts because of the debt (you pay more
tax on eqouity and no tax on interest, so interest is tax-free) CF = debt + eqouity (net income)
Debt∗r d∗Tax rate
PV of Tax Shield= = Debt∗Tax rate
rd
The frm value of a levered frm = Value of all eqouity frm + PV tax shield.
The all eqouity value = cash flow debt + eqouity (unlevered frm) i r u.
Paper “Capital Structure and Taxes: What happens when you (alsol subsidize equity?”
The paper is about Belgium, where the government decided to subsidize eqouity. The NID (Notonal
Interest Deducton) is an explicit eqouity deducton (introduced in Belgium in 2006). The obeectve was to
reduce the tax-driven distortons that favour the use of debt fnancing. The NID allows frms to deduct
from their taxable income a notonal charge eqoual to the product of the book value of eqouity * a
benchmark interest rate based on historical long-term government bonds (so it means that a X amount
of your eqouity is tax-free). Your CF at the end = net income + NID). So NID is for ex. 5% of your eqouity.
When you have a levered frm, debt is stll subsidized as well! (so not only NID is available). Net income
will be the same for the levered frm as unlevered frm,
because NID is calculated over you eqouity (eqouity is
lower when you have debt). See example:
NID was only introduced in Belgium (in 2006) = threated
country, and The Netherlands, Germany, Luxembourg
and France are the “control countries” – they are
unchanged. This empirical strategy is called diference
in diference analysis.
Data: (eqouaton)
y ikt =α +θ NID kt +d t + d k +Ψ X ikt + ε ikt
The dummy variable: θ NID kt will take value 1 if your
company is located in Belgium afer 2006 and take value 0 if itts about the control countries. (only
important variable for us)
Data: they observed the countries before and afer the treatment of the NID (2002-2009). They had on
average 6 observatons per type frm (diferent frms) (sample more than 1 million, 235,000 uniqoue
frms).
This fgure is only related to Belgium frms. The vertcal axes:
Eqouity over total assets in %. orizontal axes: years (2005 is the
last year before the reform). As you can see they already started
to use more eqouity before the NID was introduced (but the
biggest increase was afer 2005).
The fgure below (frm level analysis eqouity rato = Belgium –
control countries):
doted line is the
