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Analysis of Financial
Markets 3

Analysis of Financial Markets 3

Investment Decisions: Reminder

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Analysis of Financial Markets 3

Financing Decisions (New Topic)

Capital Structure

O How do the shares of equity and debt financing affect the firm's discount rate?
O And what is the optimal mix?

Analysis of Financial Markets 3

Equity vs. Debt: Cost of equity
No fixed schedule of mandatory repayments like in the case of debt. A firm may choose
to never pay dividends. Is equity therefore costless?
No. Shareholders require their opportunity cost of capital, i.e., the return on the next-
best alternative of the same risk
Dividend is not the only source of value, price increases are another source
How can managers estimate the cost of equity?
By solving, for an observed stock price, an equity valuation model like the DDM with
Constant Growth in reverse:

In equilibrium (i.e., absent arbitrage opportunities), the stock price reveals the correct
opportunity cost of the firm's equity (given the other parameters)

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Analysis of Financial Markets 3

Equity vs. Debt

Analysis of Financial Markets 3

Equity vs. Debt
Observations:
Whether is risk-free or not, debt remains generally less risky than equity since creditors
are paid first
Equity financing is more expensive than debt financing
Distinction between debt and equity only relevant if future cash flows from business
operations are uncertain
O Otherwise, in a world of certain expectations (see Fisher Model), both types of claimants
could forecast cash flows accurately and would require the risk-free rate.
Central question: Can the financial manager maximise firm value by finding the optimal
financing mix, i.e., the capital structure that minimises the average cost of capital?

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Analysis of Financial Markets 3

Equity vs. Debt
The capital structure of the firm will vary
The mix of equity and debt will affect the discount rate with which we discount
the future cashflows
…and thus firm value
We call this single discount rate the Weighted Average Cost of Capital (WACC),
which reflects the relative proportions of equity and debt in this capital structure

Analysis of Financial Markets 3

WACC

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Analysis of Financial Markets 3

Financial Leverage

Analysis of Financial Markets 3

Financial Leverage

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Analysis of Financial Markets 3

Modigliani-Miller

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Analysis of Financial Markets 3

Modigliani-Miller: Explanation

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Analysis of Financial Markets 3

Modigliani-Miller Propositions Returns

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Analysis of Financial Markets 3

Modigliani-Miller Propositions Returns Graphically

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Analysis of Financial Markets 3

MM Conclusions
In a perfect capital market in equilibrium, capital structure decisions are irrelevant as
they cannot create any value. Two firms that are entirely identical except for their
leverage must have the same value
O This is because investors can use the perfect and complete capital market to transform
an existing cashflow stream into one that fits their (risk) preferences without any loss (by
the same argument as the Shareholder Unanimity conclusion in the Fisher model)
O The cost of equity increases in the leverage ratio. However, higher returns entail higher
risks
For valuation purposes, the employed discount rate should be rA= rE(0) if the cashflows
“to the firm", i.e., to the debt and equity holders
rE(λ) if the cashflows “to the equity" only

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Analysis of Financial Markets 3

MM Example
Executive Cheese has issued debt with a market value of $100 million and has
outstanding 15 million shares with a market price of $10 a share. It now announces that
it intends to issue a further $60 million of debt and to use the proceeds to buy back
common stock. Debtholders, seeing the extra risk, mark the value of the existing debt
down to $70 million
a)How is the market price of the stock affected by the announcement?
b)How many shares can the company buy back with the $60 million of new debt it
issues?
c)What is the market value of the firm(equity plus debt) after the change in capital
structure?
d)What is the debt ratio after the change in structure?
e)Who (if anyone) gains or loses?

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Analysis of Financial Markets 3

MM Example
Executive Cheese has issued debt with a market value of $100 million and has
outstanding 15 million shares with a market price of $10 a share. It now announces that
it intends to issue a further $60 million of debt and to use the proceeds to buy back
common stock. Debtholders, seeing the extra risk, mark the value of the existing debt
down to $70 million
a)How is the market price of the stock affected by the announcement?
b)How many shares can the company buy back with the $60 million of new debt it
issues?
c)What is the market value of the firm(equity plus debt) after the change in capital
structure?
d)What is the debt ratio after the change in structure?
e)Who (if anyone) gains or loses?

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Analysis of Financial Markets 3

MM Example 3 solution

a) How is the market price of the stock affected by the announcement? E increases by 30 million, the
amount of the value loss of existing debt. The price of the stock hence increases to ($150million +
$30million) /15million shares = $12
b) How many shares can the company buy back with the $60 million of new debt it issues? Since the
shares are worth $12, the company can buy back $60milllion /$12 = 5 million shares
c) What is the market value of the firm (equity plus debt) after the change in capital structure? Change in
capital structure leaves V unchanged: Equity + Debt = (10 million x $12) + $130 million = $250 million
d) What is the debt ratio after the change in structure? After the change, the debt ratio is Debt/(Debt +
Equity)=$130million/$250 million=0.52
e) Who (if anyone) gains or loses? The investors in the existing debt lose $30 million while the
shareholders gain this amount. The value of each share increases by: $30 million/15 million shares= $2
(Intuition: As the firm borrows more, more of that risk is transferred from stockholders to bondholders.)

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