The Key Questions of Corporate Finance

Valuation:
How do we distinguish between good
investment projects and bad ones?
Financing:
How should we finance the investment projects
we choose to undertake?

Financing Policy
1. Real investment policies imply funding needs.
2. We have tools to forecast the funding needs to follow a given
real investment policy
3. But what is the best source of funds? Internal funds (i.e.,
cash)?
Debt (i.e., borrowing)?
Equity (i.e., issuing stock)?
Moreover, different kinds of ...
internal funds (e.g., cash reserves vs. cutting dividends)
debt (e.g., Banks vs. Bonds)
equity (e.g., VC vs. IPO)

 Capital Structure
Capital Structure represents the mix of claims
against a firms assets and free cash flow
Some characteristics of financial claims:

Payoff structure (e.g. fixed promised payment)

Priority (debt paid before equity)
Restrictive Covenants
Voting rights Options (convertible securities, call
provisions, etc)

We focus on leverage (debt vs. equity) and how

it can affect firm

 Choosing an Optimal Capital Structure

Is there an optimal capital structure, i.e., an
optimal mix between debt and equity?
More generally, can you add value on the RHS
of the BS by following a good financial policy?
If yes, does the optimal financial policy depend
on the firms operations (Real Investment
policy), and how?

Table 1: Pattern of security issue over 1997-2007.

A balanced panel of 585 manufacturing firms from Capitaline Plus data base is used. The sample
period is 1995 to 2007. An equity issue is an event of net equity being positive while debt issue is
captured as net debt being positive.

Year

Equity Issue

Debt Issue

1997

24.3%

62.8%

1998

20.5%

61.0%

1999

16.5%

57.2%

2000

16.2%

57.5%

2001

12.9%

53.6%

2002

11.1%

45.3%

2003

9.8%

45.6%

2004

14.2%

44.3%

2005

16.5%

54.4%

2006

21.8%

52.6%

2007

24.3%

56.5%

17.1%

53.7%

Over all

Table 2: Pattern of security issue over 19972007.

Year

Pure
Equity

Pure Debt Joint Issue None

1997

0.08

0.46

0.17

0.30

1998

0.07

0.47

0.14

0.32

1999

0.06

0.47

0.10

0.36

2000

0.06

0.47

0.10

0.36

2001

0.05

0.46

0.07

0.41

2002

0.06

0.40

0.05

0.49

2003

0.06

0.41

0.04

0.49

2004

0.08

0.39

0.06

0.47

2005

0.07

0.45

0.09

0.38

2006

0.09

0.40

0.13

0.38

2007

0.08

0.40

0.16

0.35

Over all

0.07

0.44

0.10

0.39

Companies and Industries Vary in Their Capital

Structures
Industry
Debt Ratio* (%)
Electric and Gas
43.2
Food Production
22.9
Paper and Plastic
30.4
Equipment
19.1
Retailers
21.7
Chemicals
17.3
Computer Software
3.5
Average over all industries
21.5%

* Debt Ratio = Ratio of book value of debt to the sum of the book
value of debt plus the market value of equity.

Returns
Average Annual Rate Average rates of return on Treasury bills, government
bonds, corporate bonds, and common stocks, 1926-1997 (figures in percent per
year)
Average
Portfolio

Nominal

Treasury bills
3.8
Government bonds
5.6
Corporate bonds 6.1
Common stocks (S&P 500) 13.0
Small-firm common stocks 17.7

Risk Premium
Real

(over T-Bills)

0.7
2.6
3.0

0.0
1.8
2.3

9.7
14.2

9.2
13.9

Source: Ibbotson Associates, Inc., 1998 Yearbook (Brealey & Myers p.155)

Plan of Attack
1. Modigliani-Miller Theorem:
Capital Structure is irrelevant

2. Whats missing from the M-M view?

Taxes

Costs of financial distress

Other factors

M-Ms Irrelevance Theorem

MM Theorem (without taxes for now).
Financing decisions are irrelevant for firm value. In
particular, the choice of capital structure is irrelevant.
Proof:
From Finance Theory,
1. Purely financial transactions do not change the total cash
flows and are therefore zero NPV investments.
2. With no arbitrage opportunities, they cannot change the total
price
Thus, they neither increase nor decrease firm value.
Q.E.D.

Get the BM example

Indirect cost : Debt Overhang

Capital Structure 3