Advanced Corporate Finance
Lecture 1
Finance sources of companies can be internal capital and external capital. Internal capital is retained
earnings; profits that are not paid back to shareholders but used to finance investment, current
expenses, etc..
External capital can be debt; an amount of money borrowed by one party from another. A debt
arrangement is under the condition that it is to be paid back at a later date, usually with interest. The
debtholders do not have voting rights. Debt is a senior claim to equity, they will get their money back
faster.
Equity holders are compensated with a dividend. The value of dividend is not predetermined. Equity
holders receive their claims only after those of the debtholders are satisfied. Equity holders do have
the right to vote at the general meeting of shareholders.
The academic definition of leverage is the ratio debt / equity or debt / total assets. The industry
definition of leverage is debt / EBIT. It is usually indicated with 3x, 4x 3x = three years of earnings
levels and we will pay back our debt.
Leverage when debt is issued or paid back or equity is issued or paid back.
Modigliani-miller irrelevance theorem. They have some assumptions:
- Perfect financial markets
o Competitive: individuals and firms are price-takers.
o Frictionless: no transaction costs, etc.
o All agents are rational.
- All agents have the same information
- No bankruptcy costs
- No taxes
The original propositions of Modigliani-Miller (MM-proposition I): a firm’s total market value is
independent of its capital structure. The value of a firm is the present discounted value of future cash
flows. When a firm issues debt and equity securities, it splits its cash flows into two streams: safe
stream to bondholders and risky stream to stockholders. M&M proposition 1 says that firm value is
determined by the real assets. The firms cannot change their value by splitting cash flows into two
different streams. So capital structure is irrelevant.
Now a calculating example of M&M proposition 1. Say an investment alternative, with initial
investment = $5000. EBIT will then be $1000 forever. Required return on unlevered equity = 10%.
Interest rate =5%.
In an unlevered example: Levered example:
Equity = $5000, debt = 0 Equity = 4000
EBIT= $1000 Debt =1000
Interest = 0 EBIT = 1000
interest = -50 (0,05*1000)
EBT =1000
EBT=950
Cash flows debt + equity = 1000
Cassh flows debt + equity = 1000
1
,M&M just says that Value levered = Value unlevered. V L=Vu.
Value of unlevered = D+E, but D =0
So this was MM-proposition I, now MM proposition II: A firm’s cost of equity increases with its D/E
ratio.
The weighted average cost of capital =
So if WACC > rd (which is almost always the case), then r E is
increasing with D/E. This is intuitive; increasing debt makes equity riskier, which increases the
expected returns that investors demand.
Higher debt ratios lead to greater risk and higher required returns (to compensate for the additional
risk). This risk consists of two types: business risk (typical enterprise risk, not related to debt) and
financial risk (risk of the equity investment, because of the leverage ratio).
Say there is a company with 100 assets and 100 equity (no debt). If the company does well, and
assets rise up to 120, then equity will become 120. If the company does poorly, assets become 90
and equity will become 90. So you can gain 20% or lose 10% of the initial investment with 50%
probability. The shareholders expected returns will be 5%. Here, business risk = financial risk.
Now, the same company, but 50 debt and 50 equity. Say that the company does well and assets
become 120, then debt = 50, equity =70. If company does not do well (asset = 90), debt = 50 and
equity = 40. So equity holders gain 40% or lose 20% with the same probability, so shareholders
expected return is 10$. Business risk < financial risk. So the financial risk is higher (+40% and -20%)
than the business risk (asset become 120 or 90 (+20% and -10%)).
So financial risk is the additional risk placed on the common stockholders as a result of the decision
to finance with debt. Debt is senior to equity; equity take (almost) all the risks. So, leverage increases
shareholder risk. Leverage also increases the return on equity; to compensate for the higher risk.
The risk of a leveraged firm increases, as D/E increases.
Now, MM IV = win-win fallacy; they undermine the statement that debt is better
because some investors prefer debt to equity. Different investors prefer different consumption
streams; they may prefer different financial assets. Financial policy serves these different clienteles. It
is called the clienteles theory or financial marketing theory. Some investors prefer safe assets (debt),
others prefer risky assets (equity).
2
,According to MM, companies should not care about investors’ preferences for financial assets.
Investors’ utility depends on consumption, not financial assets. Investors can undertake the same
transactions that firms undertake, so they will not pay a premium to firms to undertake these
transactions on their behalf.
An example; any combination of securities is as good as any other. Two firms with the same
operating income. Firm U = unlevered, Firm L = levered.
strategy 1: buy 1% of firm U’s equity. Dollar investment = 0,01*Vu. Dollar return = 0,01*profits.
Strategy 2: buy 1$ of firm L’s equity and debt.
Both strategies give the same payoff; firm’s leverage does not affect investors’ returns.
Strategy 3: buy 1% of firm U’s equity and borrow on your own account 0,01D L (home-made leverage).
So you borrow 0,01Vu to buy this value.
Strategy 4: buy 1% of firm L’s equity. Dollar investment = 0,01*E L = 0,01 * (V L – DL)
The dollar return = 0.01 (Profits – interest).
So managers should not care about the risk preferences of the investors. The investors have the
ability to borrow and lend for their own account (and at the same rate as firms) so that they can
‘undo’ any changes in firm’s capital structure.
Concluding, MM is not a literal statement about the real world, but it helps you understand. Value is
created only by operating assets (left side of the balance sheet). A firm’s financial policy should be
(mostly) a means to support the operating policy, not an end in itself.
So of all assumptions, we’ll now remove the assumption of no taxes. Usually, companies pay less
taxes on debt than equity. This has an impact on efficiency (taxes and subsidies may distort
otherwise socially optimal decisions) and financial stability (companies may issue ‘too much’ debt,
putting pressure on the banking system). Corporate rates also are often lower than the personal
rates.
Now, we’ll look at MMI proposition with Taxes. Still initial investment $5000. EBIT $1000 forever. Ru
= 10% = required return on unlevered equity.
Interest rate = 5% Levered
Equity = 4000, debt = 1000
Unlevered EBIT = 1000
equity = 5000, debt = 0 Interest = 0,05*1000=50
Ebit = 1000 EBT=950
No interest, so EBT = 1000 Tax (40%) = -380
Net income -=570
Cash flows debt + equity = 620 = 50+570
3
, Tax (40%) = -400
net income 600
cash flows debt + equity = 6oo
So it is beneficial to have debt. The present value of the tax shield =
So here, tax benefit = 1000* 0,05 * 40% tax rate = 2-. PV of 20
in perpetuity = 20/0,05 = $400. NOTE: you take the interest rate.
The firm value = value of all equity firm + PV tax shield.
All equity value = .10 = 6000 (NOTE: you take the equity rate)
PV tax shield = 400
Firm value with debt = 6400 compared to unlevered firm value of 6000.
What happens when you subsidize equity?
initial investment = 5000
EBIT = 1000
Ru = 10% = required return on unleverd equity
Notional interest deduction (NID) = 5% (Subsidy of equity)
So you have the same cash flows debt + equity again. Belgium tried this, and compared to the
‘control countries’ around Belgium (which did not change tax policies), the following results came.
Looking at it this way, it is called a difference in difference analysis.
Yikt = company I, in country k, in year t.
Yikt is the total equity to total assets or total debt to total assets.
NIDkt is our main variable; our dummy variable that will be 1 for firms located in Belgium after the
implementation of the NID policy.
The before NID is our main focus; what’s the impact of the policy?
The equity-to-total assets ratio increased for average leveraged companies in Belgium after the
reform. For small companies in Belgium, the difference was way smaller: the equity-to-total assets
ratio was only a little bit higher compared to control countries. So the change was bigger for big
companies in Belgium.The effective tax rates for companies in Belgium is lower, because of the
4
Lecture 1
Finance sources of companies can be internal capital and external capital. Internal capital is retained
earnings; profits that are not paid back to shareholders but used to finance investment, current
expenses, etc..
External capital can be debt; an amount of money borrowed by one party from another. A debt
arrangement is under the condition that it is to be paid back at a later date, usually with interest. The
debtholders do not have voting rights. Debt is a senior claim to equity, they will get their money back
faster.
Equity holders are compensated with a dividend. The value of dividend is not predetermined. Equity
holders receive their claims only after those of the debtholders are satisfied. Equity holders do have
the right to vote at the general meeting of shareholders.
The academic definition of leverage is the ratio debt / equity or debt / total assets. The industry
definition of leverage is debt / EBIT. It is usually indicated with 3x, 4x 3x = three years of earnings
levels and we will pay back our debt.
Leverage when debt is issued or paid back or equity is issued or paid back.
Modigliani-miller irrelevance theorem. They have some assumptions:
- Perfect financial markets
o Competitive: individuals and firms are price-takers.
o Frictionless: no transaction costs, etc.
o All agents are rational.
- All agents have the same information
- No bankruptcy costs
- No taxes
The original propositions of Modigliani-Miller (MM-proposition I): a firm’s total market value is
independent of its capital structure. The value of a firm is the present discounted value of future cash
flows. When a firm issues debt and equity securities, it splits its cash flows into two streams: safe
stream to bondholders and risky stream to stockholders. M&M proposition 1 says that firm value is
determined by the real assets. The firms cannot change their value by splitting cash flows into two
different streams. So capital structure is irrelevant.
Now a calculating example of M&M proposition 1. Say an investment alternative, with initial
investment = $5000. EBIT will then be $1000 forever. Required return on unlevered equity = 10%.
Interest rate =5%.
In an unlevered example: Levered example:
Equity = $5000, debt = 0 Equity = 4000
EBIT= $1000 Debt =1000
Interest = 0 EBIT = 1000
interest = -50 (0,05*1000)
EBT =1000
EBT=950
Cash flows debt + equity = 1000
Cassh flows debt + equity = 1000
1
,M&M just says that Value levered = Value unlevered. V L=Vu.
Value of unlevered = D+E, but D =0
So this was MM-proposition I, now MM proposition II: A firm’s cost of equity increases with its D/E
ratio.
The weighted average cost of capital =
So if WACC > rd (which is almost always the case), then r E is
increasing with D/E. This is intuitive; increasing debt makes equity riskier, which increases the
expected returns that investors demand.
Higher debt ratios lead to greater risk and higher required returns (to compensate for the additional
risk). This risk consists of two types: business risk (typical enterprise risk, not related to debt) and
financial risk (risk of the equity investment, because of the leverage ratio).
Say there is a company with 100 assets and 100 equity (no debt). If the company does well, and
assets rise up to 120, then equity will become 120. If the company does poorly, assets become 90
and equity will become 90. So you can gain 20% or lose 10% of the initial investment with 50%
probability. The shareholders expected returns will be 5%. Here, business risk = financial risk.
Now, the same company, but 50 debt and 50 equity. Say that the company does well and assets
become 120, then debt = 50, equity =70. If company does not do well (asset = 90), debt = 50 and
equity = 40. So equity holders gain 40% or lose 20% with the same probability, so shareholders
expected return is 10$. Business risk < financial risk. So the financial risk is higher (+40% and -20%)
than the business risk (asset become 120 or 90 (+20% and -10%)).
So financial risk is the additional risk placed on the common stockholders as a result of the decision
to finance with debt. Debt is senior to equity; equity take (almost) all the risks. So, leverage increases
shareholder risk. Leverage also increases the return on equity; to compensate for the higher risk.
The risk of a leveraged firm increases, as D/E increases.
Now, MM IV = win-win fallacy; they undermine the statement that debt is better
because some investors prefer debt to equity. Different investors prefer different consumption
streams; they may prefer different financial assets. Financial policy serves these different clienteles. It
is called the clienteles theory or financial marketing theory. Some investors prefer safe assets (debt),
others prefer risky assets (equity).
2
,According to MM, companies should not care about investors’ preferences for financial assets.
Investors’ utility depends on consumption, not financial assets. Investors can undertake the same
transactions that firms undertake, so they will not pay a premium to firms to undertake these
transactions on their behalf.
An example; any combination of securities is as good as any other. Two firms with the same
operating income. Firm U = unlevered, Firm L = levered.
strategy 1: buy 1% of firm U’s equity. Dollar investment = 0,01*Vu. Dollar return = 0,01*profits.
Strategy 2: buy 1$ of firm L’s equity and debt.
Both strategies give the same payoff; firm’s leverage does not affect investors’ returns.
Strategy 3: buy 1% of firm U’s equity and borrow on your own account 0,01D L (home-made leverage).
So you borrow 0,01Vu to buy this value.
Strategy 4: buy 1% of firm L’s equity. Dollar investment = 0,01*E L = 0,01 * (V L – DL)
The dollar return = 0.01 (Profits – interest).
So managers should not care about the risk preferences of the investors. The investors have the
ability to borrow and lend for their own account (and at the same rate as firms) so that they can
‘undo’ any changes in firm’s capital structure.
Concluding, MM is not a literal statement about the real world, but it helps you understand. Value is
created only by operating assets (left side of the balance sheet). A firm’s financial policy should be
(mostly) a means to support the operating policy, not an end in itself.
So of all assumptions, we’ll now remove the assumption of no taxes. Usually, companies pay less
taxes on debt than equity. This has an impact on efficiency (taxes and subsidies may distort
otherwise socially optimal decisions) and financial stability (companies may issue ‘too much’ debt,
putting pressure on the banking system). Corporate rates also are often lower than the personal
rates.
Now, we’ll look at MMI proposition with Taxes. Still initial investment $5000. EBIT $1000 forever. Ru
= 10% = required return on unlevered equity.
Interest rate = 5% Levered
Equity = 4000, debt = 1000
Unlevered EBIT = 1000
equity = 5000, debt = 0 Interest = 0,05*1000=50
Ebit = 1000 EBT=950
No interest, so EBT = 1000 Tax (40%) = -380
Net income -=570
Cash flows debt + equity = 620 = 50+570
3
, Tax (40%) = -400
net income 600
cash flows debt + equity = 6oo
So it is beneficial to have debt. The present value of the tax shield =
So here, tax benefit = 1000* 0,05 * 40% tax rate = 2-. PV of 20
in perpetuity = 20/0,05 = $400. NOTE: you take the interest rate.
The firm value = value of all equity firm + PV tax shield.
All equity value = .10 = 6000 (NOTE: you take the equity rate)
PV tax shield = 400
Firm value with debt = 6400 compared to unlevered firm value of 6000.
What happens when you subsidize equity?
initial investment = 5000
EBIT = 1000
Ru = 10% = required return on unleverd equity
Notional interest deduction (NID) = 5% (Subsidy of equity)
So you have the same cash flows debt + equity again. Belgium tried this, and compared to the
‘control countries’ around Belgium (which did not change tax policies), the following results came.
Looking at it this way, it is called a difference in difference analysis.
Yikt = company I, in country k, in year t.
Yikt is the total equity to total assets or total debt to total assets.
NIDkt is our main variable; our dummy variable that will be 1 for firms located in Belgium after the
implementation of the NID policy.
The before NID is our main focus; what’s the impact of the policy?
The equity-to-total assets ratio increased for average leveraged companies in Belgium after the
reform. For small companies in Belgium, the difference was way smaller: the equity-to-total assets
ratio was only a little bit higher compared to control countries. So the change was bigger for big
companies in Belgium.The effective tax rates for companies in Belgium is lower, because of the
4
