ECON 3420 Discussion 6

ECON 3420 Discussion 6 - ECON 3420A Financial Economics...

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ECON 3420A Financial Economics 2010-2011 Term 1 Discussion 6: Corporate Finance (I) 1. 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 the 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.
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2. Discuss how dividend policy can increase the value of a company. In a world of symmetric information, dividend policy actually has no effect on the value of the firm, given no tax system. However, in a world of asymmetric information, where investors do not have as much
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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 Discussion 6 - ECON 3420A Financial Economics...

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