I.3: Two-Fund Separation & MM
Advanced Corporate Finance, NYU Stern
I.3: Two-fund separation & MM
Risk-return preferences (in the meanvariance framework)
1. Each investor picks a
portfolio (PF) on the
Dashed line = PFs
Instructions on how to prepare for the class discussion of The Tip of the
Iceberg: JP Morgan Chase and Bear Stearns (A)
1. Read the entire case.
2. Read the Appendix (Brief Overview of U.S. Financial Services
a. Difference between commercial
Outline of the course
Part I: Irrelevance
Part II: Capital structure
How does capital structure affect the real decisions of a firm?
! Bankruptcy, financial distress, debt overhang, risk shifting, debt-equity
! Cases: : Bear S
Idea that there is a trade-off between the tax benefits and the increased expected COFD
(Pr(FD)Pr(COFD) of taking on debt.
Graph of Firm Value against Leverage: in an MM world, it should be a straight horizontal
line; however, we have a c
Inefficiencies of public vs. private
- Benefits: no disclosure, less MA (no PB), less regulation
- Costs: greater underinvestment, sub-optimal risk-sharing, illiquidity
- Benefits: access to capital (lower underinvestment), better risk-s
BL: MA destroys value. When actual PB is observed, it is just the tip of the iceberg
because there are actually three costs:
1. Underinvestment = inability to raise up to FV due to threat of PB
2. Sub-optimal risk-sharing = i.e. not selling 100% due to th
Agency and Ownership
There are two types of conflicts:
i) Conflict between equity and debt holders (only when you have too much debt, right?)
ii) Conflict between the providers of financial capita
Advanced Corporate Finance Notes
When you have to sell less than optimal shares to credibly convince the investor that you
are a good firm.
Calculating how much to sell (MUST TAKE THE PERSPECTIVE OF THE LOW
1. Set up th
Sticks and carrots intuition for firm managers
Debt = sticks; minimum obligation is like a punishment for bad performance
Equity = carrots; excess return gets rewarded
Graph: increasing performance sensitivity (horizontal) vs. decreasing
Whether to sell shares or not?
NOTE: once you decide to sell , assume you decide to sell
1. Decide whether to sell shares or not as follows:
- Begin with = 0% map out payoffs
- Then try = 100% map out payoffs
- Compare the payoffs, and decide which is hi
What is transaction cost?
Transaction costs are costs incurred during the process of changing ones capital structure
(raising debt/equity). It is important because transactions must be designed to minimize
these friction costs. Main type of
Takeaways of adverse selection
Supposed you have V* which is a point below which the firm will lose money. For good
firms, V* will always be between the maximum and minimum valuation, whereas for a
bad firm, V* will be below the minimum valuation.