ECON 3420A Financial Economics
2010-2011 Term 1
Discussion 6: Corporate Finance (I)
Imagine a world of certainty. Suppose you own the copyright of a book. You are
thinking of starting a company to publish your book. Because of complete certainty,
the future sales and earnings of your company are certain.
To raise funding for
your company, you can either issue bonds or shares to your friends. Thinking in
common sense terms, argue that the value of your company cannot depend on how
you finance your company. What does the value of your firm depend on?
The value of the firm depends on the future expected income as well as the sum of the
value of the bonds and shares issued. It is because the real side of the firm is independent
of the financial side of the firm according to the Modigliani-Miller Theorem.
The certainty and the uncertainty are not critical in this case. The difference between
them is that when calculating the expected value of the firm in the uncertainty case,
probability should be taken into consideration. The value of the firm still depends on the
expected future earning, but not how the owner finances the firm. Under
Modigliani-Miller Theorem, the value of the firm is the expected future earnings of
the firm. For example, as there is complete certainty in this case, you know that you
will earn $10000 in publish the book. If you issue 100 shares, each share value
10000/100 = $100. The value of the firm is 100*100 = $10000. Or, you issue 3000
bonds, of which each unit entitled $1 repayment, and 2000 shares. Then, each bond
worth 3000/3000=1 and each share worth (10000-3000)/2000=7/2. Then the value of
the firm is 1*3000 + 7/2*2000 = $10000. Therefore, no matter what is the company’s
capital structure, the expected future earnings of the firm is the same. Hence, the value
of your company cannot depend on how you finance your company.
The critical factor is that whether the information is symmetric or asymmetric. If there is
asymmetric information, the Modigliani-Miller Theorem doesn’t hold. For instance the
future profitability of the firm is not satisfactory, but the firm misleads the investor so
that they believe the value of the firm is high. Hence, the financial side as well as the
market value of the firm cannot truly reflect the expected future earning of the firm. The
value of the firm depends of the expected future earnings so the firm. For example, in
this case, the future sales revenue received from the book sales which may be affected
by the popularity of the book, sales strategy as well as the whether the book suit
people’s taste, etc.