ACF Subjects
Italic = paper
1. Back to the basics
I. Modigliani Miller Irrelevance theorem
i. Assumptions:
1. Perfect financial markets
a. Competitive, individuals and firms are price-takers.
b. Frictionless
c. All agents are rational.
2. All agents have the same information.
a. Adverse selection
i. Used car buyer will buy a lemon because she is not
paying full price → peaches leave the market and
lemons remain.
ii. Insurance company → standard risk premium will
result in people with poor health buy it more.
b. Moral hazard
3. No bankruptcy costs.
a. There are, of course. Look on next page.
(direct/indirect/selfish)
4. No taxes
ii. MM’s most basic message:
1. Value is created only by operating assets.
2. A firm’s financial policy should be a means to support the operating
policy, not an end in itself.
iii. Propositions
1. MM-Proposition I
a. Firms total value is independent of capital structure.
i. Firm value is determined by the real assets.
ii. Firms cannot change their value by splitting cash
flow into two different streams.
iii. Capital structure is irrelevant.
iv. Value levered company == value unlevered company
b. M&M Proposition with taxes
i. Cash flows of a levered company are higher than a
unlevered company as the interest paid on the debt
is tax free.
2. MM-Proposition II
a. A firm’s cost of equity increases with its debt-equity ratio.
i. Increasing debt makes equity riskier, increasing the
expected returns [equity] investors demand.
𝐷 𝐸
ii. 𝑊𝐴𝐶𝐶 = (𝐷+𝐸) 𝑟𝑑 + (𝐷+𝐸) 𝑟𝑒
𝐷
iii. 𝑟𝑒 = (𝑊𝐴𝐶𝐶 − 𝑟𝑑) 𝐸 + 𝑊𝐴𝐶𝐶
𝑫
iv. If 𝑊𝐴𝐶𝐶 > 𝑟𝑑, 𝒓𝒆 𝐢𝐬 𝐢𝐧𝐜𝐫𝐞𝐚𝐬𝐢𝐧𝐠 𝐰𝐢𝐭𝐡
𝑬
v. Two types of risk
, ACF Subjects
Italic = paper
1. Business risk (enterprise risk, rocket
company is risky [not related to debt])
2. Financial risk (risk of the equity investment)
a. Debt is senior to equity.
b. Debtholders have the right to a fixed
claim in case of liquidation.
3. Dividend irrelevance
a. A firm’s total market value is independent of its dividend
policy.
b. [Week 4: Payouts]
i. Since investors do not need dividends to convert
shares into cash, dividend policy will have no impact
on the value of the firm.
1. As investors can always do their own
transaction of shares (homemade dividend)
to match their individual preference and
create whatever income stream the prefer
(think of Bob investor).
ii. Firms should never forgo positive NPV projects to
increase a dividend (or to pay a dividend for the first
time)
4. Investor indifference
a. Individual investors are indifferent to all firms’ financial
policies.
II. Taxes and capital structure
i. Corporations pay less tax on debt versus equity.
1. What happens when you subsidize equity?
a. Belgium: NID (Notional interest deduction)
i. Equity deduction in Belgium in 2006
ii. Belgium treatment group, NL GER FRA and LUX
control groups
b. Results:
i. Induced Belgian companies to increase the use of
equity, decrease the use of debt.
ii. Equity rates increase, leverage ratios decline.
iii. Effect is not large for small firms.
ii. Key concepts
1. academic leverage = 𝑑𝑒𝑏𝑡/𝑒𝑞𝑢𝑖𝑡𝑦
2. industry leverage == 𝑑𝑒𝑏𝑡/𝐸𝐵𝐼𝑇
a. “3x ==, three years of earnings levels and we will pay back
our debt”
3. Internal capital (retained earnings)
4. External capital (debt v. equity seniority
iii. Present value of a tax shield
𝐷𝑒𝑏𝑡∗𝑟𝑑∗𝑇𝑎𝑥 𝑟𝑎𝑡𝑒
1. PV of tax shield = = 𝐷𝑒𝑏𝑡 ∗ 𝑇𝑎𝑥 𝑟𝑎𝑡𝑒
𝑟𝐷
a. Tax benefit = $1000 * 5% * 40% = 20$
b. PV of 20 perpetuity = 20/0.05 = $400
Italic = paper
1. Back to the basics
I. Modigliani Miller Irrelevance theorem
i. Assumptions:
1. Perfect financial markets
a. Competitive, individuals and firms are price-takers.
b. Frictionless
c. All agents are rational.
2. All agents have the same information.
a. Adverse selection
i. Used car buyer will buy a lemon because she is not
paying full price → peaches leave the market and
lemons remain.
ii. Insurance company → standard risk premium will
result in people with poor health buy it more.
b. Moral hazard
3. No bankruptcy costs.
a. There are, of course. Look on next page.
(direct/indirect/selfish)
4. No taxes
ii. MM’s most basic message:
1. Value is created only by operating assets.
2. A firm’s financial policy should be a means to support the operating
policy, not an end in itself.
iii. Propositions
1. MM-Proposition I
a. Firms total value is independent of capital structure.
i. Firm value is determined by the real assets.
ii. Firms cannot change their value by splitting cash
flow into two different streams.
iii. Capital structure is irrelevant.
iv. Value levered company == value unlevered company
b. M&M Proposition with taxes
i. Cash flows of a levered company are higher than a
unlevered company as the interest paid on the debt
is tax free.
2. MM-Proposition II
a. A firm’s cost of equity increases with its debt-equity ratio.
i. Increasing debt makes equity riskier, increasing the
expected returns [equity] investors demand.
𝐷 𝐸
ii. 𝑊𝐴𝐶𝐶 = (𝐷+𝐸) 𝑟𝑑 + (𝐷+𝐸) 𝑟𝑒
𝐷
iii. 𝑟𝑒 = (𝑊𝐴𝐶𝐶 − 𝑟𝑑) 𝐸 + 𝑊𝐴𝐶𝐶
𝑫
iv. If 𝑊𝐴𝐶𝐶 > 𝑟𝑑, 𝒓𝒆 𝐢𝐬 𝐢𝐧𝐜𝐫𝐞𝐚𝐬𝐢𝐧𝐠 𝐰𝐢𝐭𝐡
𝑬
v. Two types of risk
, ACF Subjects
Italic = paper
1. Business risk (enterprise risk, rocket
company is risky [not related to debt])
2. Financial risk (risk of the equity investment)
a. Debt is senior to equity.
b. Debtholders have the right to a fixed
claim in case of liquidation.
3. Dividend irrelevance
a. A firm’s total market value is independent of its dividend
policy.
b. [Week 4: Payouts]
i. Since investors do not need dividends to convert
shares into cash, dividend policy will have no impact
on the value of the firm.
1. As investors can always do their own
transaction of shares (homemade dividend)
to match their individual preference and
create whatever income stream the prefer
(think of Bob investor).
ii. Firms should never forgo positive NPV projects to
increase a dividend (or to pay a dividend for the first
time)
4. Investor indifference
a. Individual investors are indifferent to all firms’ financial
policies.
II. Taxes and capital structure
i. Corporations pay less tax on debt versus equity.
1. What happens when you subsidize equity?
a. Belgium: NID (Notional interest deduction)
i. Equity deduction in Belgium in 2006
ii. Belgium treatment group, NL GER FRA and LUX
control groups
b. Results:
i. Induced Belgian companies to increase the use of
equity, decrease the use of debt.
ii. Equity rates increase, leverage ratios decline.
iii. Effect is not large for small firms.
ii. Key concepts
1. academic leverage = 𝑑𝑒𝑏𝑡/𝑒𝑞𝑢𝑖𝑡𝑦
2. industry leverage == 𝑑𝑒𝑏𝑡/𝐸𝐵𝐼𝑇
a. “3x ==, three years of earnings levels and we will pay back
our debt”
3. Internal capital (retained earnings)
4. External capital (debt v. equity seniority
iii. Present value of a tax shield
𝐷𝑒𝑏𝑡∗𝑟𝑑∗𝑇𝑎𝑥 𝑟𝑎𝑡𝑒
1. PV of tax shield = = 𝐷𝑒𝑏𝑡 ∗ 𝑇𝑎𝑥 𝑟𝑎𝑡𝑒
𝑟𝐷
a. Tax benefit = $1000 * 5% * 40% = 20$
b. PV of 20 perpetuity = 20/0.05 = $400
