ECON 3420 Notes 6 [Corporate Finance]

ECON 3420 Notes 6 [Corporate Finance] - Corporate Finance...

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Unformatted text preview: Corporate Finance Introduction In this chapter, we turn our attention to the sources of financing of the firm, in other words, the capital structure of the firm. There has been a lot of investigation on whether the capital structure of the firm affects its value. This investigation has relevance on whether a firm can alter its capital structure to manipulate its value. How much is a business worth? Since a business is supposed to earn profits in the future, the classical view is that the value of a business depends on future expected profits. These profits can be viewed as the residual of revenue over expenses. These profits belong to different stakeholder groups, such as creditors, bondholders, banks, and shareholders. These groups lay claim on the profits, and they are known as residual claimants. The difference between different classes of residual claimant is that the seniorities of their claim are different. For example, the claim of banks and bondholders is higher than that of ordinary shareholders, i.e. ordinary shareholders are paid after banks and shareholders are. The value of a business is equal to the value of the claims (of various seniorities) on its profits. Because the business can issue different amounts of shares, loans, and bonds, the question arises as to whether the value of the claims depends on the mixture of claims, i.e. the structure of the financing capital. Modigliani Miller Theorem In a world with perfect information, the answer to the question is: No, and it is the implication of the celebrated Modigliani-Miller Theorem. Example You have a business idea (say you have the copyright to a book) and are deciding on financing options. Your business generates a random profit. For simplicity, assume that the business lasts for only one period. It generates $600, 300, and $120 with probability of 1/3 each. The expected value of it is therefore 340. Suppose you issue 100 shares. Then each share is worth 3.4 and the total value of the business is equal to the value of the claims on its profit, which is 340. If you issue 200 units of bond and 100 shares, then each unit of bond is worth [200(1/3)+200(1/3)+120(1/3)]/200 = 13/15 and each share is worth [400(1/3)+100(1/3)+0]/100 = 5/3. The total value of claims = (13/15)(200)+(5/3)(100) = 340. Therefore, no matter how you finance your business, the value of the business is 340, the expected value of its profits. Proof of the MM Theorem Consider two firms A and B with identical future earnings, say X, which is a random variable. The two firms differ in their capital structure. Firm A issues shares and does not borrow. Firm B issues shares and also bonds amounting to B. Suppose both firms are listed on the stock exchange. For Firm A, the entire earnings X would go to the shareholders and we let P A be the price that investors are willing to pay for Firm A. (In other words P A is the price of stock times the number of shares issued. P A is called market capitalization of Firm A.) For Firm B, the is called market capitalization of Firm A....
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This note was uploaded on 03/03/2012 for the course ECON 3420 taught by Professor Kwong during the Spring '11 term at CUHK.

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ECON 3420 Notes 6 [Corporate Finance] - Corporate Finance...

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