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Lecture 2- Modeling Finc Constraints

# Lecture 2- Modeling Finc Constraints - Corporate...

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Corporate Transactions and Valuation Salvatore Cantale Modeling Financial Constraints Financial constraints come in many species and sorts and the one considered in class are just a small subset. Yet, these are every day questions that are posed to modern corporations. The financial constraints that I will consider here are: a. Target Capital Structure: Why do we need to model it? How does it change our pro formas, and what does it mean for valuation? b. Maximum Amount of Debt. How a limited amount of bank borrowing is going to change the value of a corporation? How can we model it? c. Dividend Policy: does it matter? How? How can we interpret our dividend models? Target Capital Structure: How,Why, and Some Implications for Valuation How to Model a Target Capital Structure? Please refer to the Financial Forecasting in Exhibit 1 of the file “ Modeling Capital Structure.xls” As you can see from Exhibit 1, when Debt is the PLUG, the amount of debt is determined by the need to balance the assets and the liabilities of the firm, and the equity grows because of the profitability of the firm and its dividend policy. Since the two things are quite independent, capital structure is free to float and managers have no control over it. Now suppose that you have a Target Capital Structure that can be summarized in a target Debt/Equity ratio. How can we model it in our financial forecasting? In what follows, I will elaborate a simple methodology for talking care of this issue. Notice, though, that the actual formula that I will come up with, applies to this simple problem only, and, as long as the financial forecastings are more complicated, while the line of reasoning will be the same, the actual formula that you will obtain will be different. To accomplish the goal of having a Target Capital Structure, we have first to construct our Pro Forma in such a way that the debt/equity ratio is "forced" to be as large as we want. I

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2 assume that the target level must be reached by year 1, and then the percentage of debt and equity will be such that the ratio will not change. In my model, I will have the Debt level as the PLUG again. Therefore, I have "to work" on
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Lecture 2- Modeling Finc Constraints - Corporate...

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