SUMMARY OF PAPERS
PART 1: capital structure basics
Capital structure: financing investment with:
Internal Capital:
o Retained earnings: own money, no dividend: no fixed cash flow.
Profits not paid back to shareholders, but used to finance
investments, current expenses, etc.
External Capital:
o Debt: usually no voting rights (except in bankruptcy and such),
senior to equity: claim must be paid in full before firm can make
payments to equity holders.
o Equity: no fixed cash flow: receive dividend only after debt holders
claims are satisfied, right to vote at general meeting.
Miller and Merton (1988): Modigliani-Miller Propositions
Assumptions:
1. Perfect financial markets: competitive (individuals and firms are price-
takers: no bargaining, pay for given price), all agents are rational,
frictionless (no transaction costs, no bid-ask price).
2. All agents have same information.
o Lemon markets: seller has more information than buyer. Investors
not able to distinguish; adjust price somewhere in between (more
than bad, cheaper than good). Result: bad companies enter market,
good companies stay out.
Effect is called adverse selection.
o Leads to pecking order theory: information asymmetry between
firm and market makes external finance more costly than internal
funds, debt less costly than equity.
To overcome problem: use retained earnings, then borrow
from debt market (less sensitive to asymmetric information
issues), at last issue equity.
3. Firm’s cash flows don’t depend on financial policy (no bankruptcy costs).
o Cost of financial distress: costs arising from bankruptcy or
distorted business decisions before bankruptcy.
Direct costs: legal and administrative costs.
Indirect costs: impaired ability to conduct business (lost
sales).
Selfish strategy 1: incentive to take large risks.
o Asset substitution: take large risk, invest
more in firm while it’s going bankrupt,
advantage for stockholders.
The Gamble Probability P
Win Big 10% 1
Lose Big 90% 0
Expected CF of gamble: 1000 x 0.10 = 100
o Bondholders: 300 x 0.10 = 30
o Stockholders: 1000-300 x 0.10 = 70
100
NPV =−200+ =−116.67
1.20
Expected CF without gamble:
o Bondholders: 200
o Stockholders: 0
, Selfish strategy 2: incentive toward underinvestment:
reject positive NPV projects, because too little cash in
firm (100 extra needed), advantage for bondholders.
o Cost of investment is more than firm has,
stockholders have to supply additional amount.
o Bondholders get paid first, stockholders don’t
see investment back fully.
PV bondholders without project = 200
PV stockholders without project = 0
PV bondholders with project = 300/1.1 =
272.73
PV stockholders with project = 50/1.1 –
100 = -54.55
Selfish strategy 3: milking the property.
o Liquidating dividends: pay out 200 dividend
to shareholders firm insolvent, nothing for
bondholders, plenty for former shareholders
(tactics often violate bond covenants).
o Increase perquisites.
4. No taxes: usually less tax on debt than on equity.
o Efficiency: taxes and subsidies may distort otherwise socially
optimal decisions.
o Financial stability: company may issue too much debt, putting
pressure on banking system.
Debt ×r D ×Tax Rate
PV of Tax Shield= =Debt × Tax Rate
rD
Firm value = value of all equity firm + PV tax shield
MM Propositions: help to focus on real issue, main focus should be investment
(NPV).
MM Proposition I: total market value of firm is independent of its capital
structure. Firm value determined by real assets, capital structure is irrelevant.
Value of firm: present discounted value of future cash flows:
FCF 1 FCF 2
V =E+ D=FCF 0 + + +…
1+ wacc (1+ wacc )2
o Safe stream to bondholders.
o Risky stream to stockholders.
Firm value cannot change total value of securities by splitting cash flows
into two different streams, is determined by real assets, capital structure is
irrelevant.
Unlevered Levered
Equity ( r U =0.10 ) 5000 4000
Debt ( r D=0.05 ) 1000
EBIT 1000 1000
- Interest -50
EBT 1000 950
- Tax (0%)
NI 1000 950
PART 1: capital structure basics
Capital structure: financing investment with:
Internal Capital:
o Retained earnings: own money, no dividend: no fixed cash flow.
Profits not paid back to shareholders, but used to finance
investments, current expenses, etc.
External Capital:
o Debt: usually no voting rights (except in bankruptcy and such),
senior to equity: claim must be paid in full before firm can make
payments to equity holders.
o Equity: no fixed cash flow: receive dividend only after debt holders
claims are satisfied, right to vote at general meeting.
Miller and Merton (1988): Modigliani-Miller Propositions
Assumptions:
1. Perfect financial markets: competitive (individuals and firms are price-
takers: no bargaining, pay for given price), all agents are rational,
frictionless (no transaction costs, no bid-ask price).
2. All agents have same information.
o Lemon markets: seller has more information than buyer. Investors
not able to distinguish; adjust price somewhere in between (more
than bad, cheaper than good). Result: bad companies enter market,
good companies stay out.
Effect is called adverse selection.
o Leads to pecking order theory: information asymmetry between
firm and market makes external finance more costly than internal
funds, debt less costly than equity.
To overcome problem: use retained earnings, then borrow
from debt market (less sensitive to asymmetric information
issues), at last issue equity.
3. Firm’s cash flows don’t depend on financial policy (no bankruptcy costs).
o Cost of financial distress: costs arising from bankruptcy or
distorted business decisions before bankruptcy.
Direct costs: legal and administrative costs.
Indirect costs: impaired ability to conduct business (lost
sales).
Selfish strategy 1: incentive to take large risks.
o Asset substitution: take large risk, invest
more in firm while it’s going bankrupt,
advantage for stockholders.
The Gamble Probability P
Win Big 10% 1
Lose Big 90% 0
Expected CF of gamble: 1000 x 0.10 = 100
o Bondholders: 300 x 0.10 = 30
o Stockholders: 1000-300 x 0.10 = 70
100
NPV =−200+ =−116.67
1.20
Expected CF without gamble:
o Bondholders: 200
o Stockholders: 0
, Selfish strategy 2: incentive toward underinvestment:
reject positive NPV projects, because too little cash in
firm (100 extra needed), advantage for bondholders.
o Cost of investment is more than firm has,
stockholders have to supply additional amount.
o Bondholders get paid first, stockholders don’t
see investment back fully.
PV bondholders without project = 200
PV stockholders without project = 0
PV bondholders with project = 300/1.1 =
272.73
PV stockholders with project = 50/1.1 –
100 = -54.55
Selfish strategy 3: milking the property.
o Liquidating dividends: pay out 200 dividend
to shareholders firm insolvent, nothing for
bondholders, plenty for former shareholders
(tactics often violate bond covenants).
o Increase perquisites.
4. No taxes: usually less tax on debt than on equity.
o Efficiency: taxes and subsidies may distort otherwise socially
optimal decisions.
o Financial stability: company may issue too much debt, putting
pressure on banking system.
Debt ×r D ×Tax Rate
PV of Tax Shield= =Debt × Tax Rate
rD
Firm value = value of all equity firm + PV tax shield
MM Propositions: help to focus on real issue, main focus should be investment
(NPV).
MM Proposition I: total market value of firm is independent of its capital
structure. Firm value determined by real assets, capital structure is irrelevant.
Value of firm: present discounted value of future cash flows:
FCF 1 FCF 2
V =E+ D=FCF 0 + + +…
1+ wacc (1+ wacc )2
o Safe stream to bondholders.
o Risky stream to stockholders.
Firm value cannot change total value of securities by splitting cash flows
into two different streams, is determined by real assets, capital structure is
irrelevant.
Unlevered Levered
Equity ( r U =0.10 ) 5000 4000
Debt ( r D=0.05 ) 1000
EBIT 1000 1000
- Interest -50
EBT 1000 950
- Tax (0%)
NI 1000 950
