Ch 14 Part a Leverage Risk and Return

3/30/2023
Leverage, Firm Value, and Risk| Chapter 14 Prof. Nisan Langberg
Leverage, Firm Value and Risk (Part A)

Chapter 14
Funding Alternatives The Sky Venture (Equity

financing)
The Sky Venture (Debt Modigliani and

Financing) Miller Theorem
Wrapping up
Funding Alternatives
Agenda for this Unit
Debt Equity
Cash Flow versus Control Rights
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Debt securities
Fixed Income (debt)

Notes and debentures (unsecured bonds) Private debt
Debt instruments backed by the general credit of the Loans provided by non-bank investors such as
company private debt funds
Leases and Asset-backed bonds Convertible debt

Debt instruments secured with property or assets Loans that potentially turn into ownership
share
Lines of Credit and Bank Loans

Loans provided by a bank in the form of a lumpsum
or a credit line with a predetermined limit
Equity securities
Ownership (equity)
Common Shares Equity Crowdfunding
Shares issued during IPO or SEO that pay dividends Startup equity funding for small ventures
Preferred Shares Royalty financing

Shares with payment seniority over common shares Loans provided by a bank in the form of a lumpsum
but junior to debt or a credit line with a predetermined limit
Convertible Preferred Shares

Preferred shares that convert to common shares Retained Earnings
often used by VCs When firms use retained
earnings to fund new projects
Private equity
Equity investments in privately held firms or
through LBOs
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Funding Alternatives
Control Rights Cash Flow Rights
Voting rights
Equity
Elect board of directors Dividend payments

Vote on major issues
Debt
Coupon and principal payments

Gain control in bankruptcy
Senior to equity
Financing and Business Decisions
Financing decisions Business decisions
Take a loan Develop new product How are business and

financing decisions
Issue equity Expand operations related?
Repurchase shares Reduce production

Is there an optimal
financing method?
Pay dividend Expand employee base
Refinance loans Sell a division
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Optimal Capital Structure
Cost of Equity Capital 𝒓𝑬

The expected annual return demanded by equity True or false?
holders on their capital invested
“Firms should necessarily raise
funds using the security (debt or
equity) with the lowest cost of
Cost of Debt Capital 𝒓𝑫 capital…”
The expected annual return demanded by debt

holders on their capital invested
Cross Industry Look

We estimated the average dollar amount $X of borrowing per
each $1 equity investment for companies in different industries
$9 $0.34 $0.04 $3.25

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Funding Sky with Equity
Yael’s Startup SKY
Approaching IC VC for Equity
SKY’s Market Balance Sheet
Yael’s Startup
The Investment Opportunity
Yael is thinking about a risky startup she calls SKY. The plan requires a current investment of
$800,000 at time t=0 and yields in one year, at time t=1, either a high valuation of $1,400,000
or a low valuation of $900,000 with equal probabilities.
The risk-free rate is 5%. The risk associated with these cash flows requires a risk adjusted
discount rate of 15%
Is this a good investment opportunity?
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Yael’s Startup
Firm Value
What is the value of SKY at time t=0 just after the investment of $800,000 is made?
The expected value of SKY in one year at time t=1:
𝐸 𝐶𝐹 $1,400,000 $900,000 $𝟏, 𝟏𝟓𝟎, 𝟎𝟎𝟎
So…is this a good investment

The PV at time t=0 of SKY’s future cash flows:
opportunity?
$ , , $1,000,000>$800,000 YES
𝑃𝑉 $𝟏, 𝟎𝟎𝟎, 𝟎𝟎𝟎
.
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The Funding Dilemma
Yael’s alternatives
Yael has $300,000 to invest in SKY but must raise the remaining $500,000.
Yael must choose between debt and equity financing.
Lets compare the two alternatives
Equity starting with Equity financing
Yael can approach an equity investor for funding.
Debt
Yael can approach a debt investor (bank) and

borrow at a risk free interest rate of 5%.
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Yael approaches John from IC Venture Capital (Equity)

Yael’s email to John John’s reply
Dear John, Dear Yael,

It was great talking to you last week. Thanks again I’ll be happy to invest! In return I expect 62.5%
for hearing my pitch at Innovation Capital. I had a ownership. You see, you mentioned the total
good feeling that we could work together. IC VC required investment of $800,000 and you are
would be a great match for SKY! asking me to fund exactly 62.5% of that
Any decision? investment (which is $500,000).
Sincerely, Please confirm,
How should Yael reply?
Yael John
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Yael approaches John IC Venture Capital (Equity)

Yael’s follow up email John’s reply
Dear John,
Dear Yael,
According to the cash flow projections I presented
That makes sense to me. No need to seek funding
at IC VC, after investment takes place in SKY, it will
elsewhere! We at IC VC are absolutely looking for
be worth $1 million (the present value of SKY’s
exposure in the direction of SKY. We are exited to
future cash flows). Unfortunately, I can only offer
fund SKY with $500,000 for 50% ownership.
you 50% ownership which will give IC VC in value
Our lawyers will be in touch soon to finalize the
terms the $500,000 investment.
details.
Please let me know ASAP as other investors are
Sincerely,
interested. Let’s analyze this equity deal
John
Sincerely,
Yael. 14
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Analyzing the Deal

Time t=0 Time t=1
Yael founder of SKY High Valuation of $1,400,000 (prob. half)

Ownership 50% of SKY Yael’s payoff $700,000
Worth 50% ($1 million) = $500,000 John’s payoff $700,000
John from IC VC Low Valuation of $900,000 (prob. half)

Ownership 50% of SKY Yael’s payoff $450,000
Worth 50% ($1 million) = $500,000 John’s payoff $450,000
What is John from IC VC’s expected
return on this investment?
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Calculating the Expected Return on Equity for IC VC

Time t=0 Time t=1
$700,000 𝑜𝑟 40% 𝑟𝑒𝑡𝑢𝑟𝑛 𝑝𝑟𝑜𝑏. ℎ𝑎𝑙𝑓

John from IC VC’s value of equity
Ownership 50% of SKY
Worth 50% ($1 million) = $500,000
$450,000 𝑜𝑟 10% 𝑟𝑒𝑡𝑢𝑟𝑛 𝑝𝑟𝑜𝑏. ℎ𝑎𝑙𝑓
YES John breaks even!

So…what is John from IC VC’s 𝟏 𝟏
𝟒𝟎% 𝟏𝟎% 𝟏𝟓%
expected return on this investment? 𝟐 𝟐 16
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SKY’s (Market) Balance Sheet
Assets Liabilities
Debt =0
Present Value of Market value of
SKY’s future CFs from traded securities
Equity IC VC’s
business operations
$500,000
Value of SKY
$1,000,000 Equity Yael
$500,000
17
Funding Sky with Debt
Approaching Star Bank for Debt
Calculating the value of Levered Equity
SKY’s Market Balance Sheet
18
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Yael approaches Bruce from Star Bank (Debt)

Yael’s email to Bruce Bruce’s reply
Dear Bruce, Dear Yael,

It was great talking to you last week. Thanks again I processed your loan application for $500,000. Since
for hearing my pitch at Star Bank. I had a good I cannot approve this size of a loan by myself I
feeling that we could work together. As you know I checked with my supervisor and we are happy to
am seeking a $500,000 loan from your bank. provide you with this loan. The interest rate we
Any decision? charge for such risky investments is 10%. So you are
Sincerely, looking at an annual interest payment of $50,000.
Yael Please confirm,
How should Yael reply?
Bruce
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Yael approaches Bruce from Star Bank (Debt)

Yael’s follow up email Bruce’s reply
Dear Bruce,
Dear Yael,
According to the cash flow projections I presented at
My supervisor reconsidered. Good news! Indeed
Star Bank, SKY will be worth at least $900,000.
with minimum cash flow of $900,000 your loan
Therefore, Star Bank is not facing any risk! SKY will be
does not impose default risk. No need to seek
able to repay its loan for certain!
funding elsewhere! We at Star Bank appreciate
I will only do business with Star Bank if I am offered
your business. We are exited to provide the loan at
the risk free interest rate of 5%.
5% interest, i.e., $25,000 annual interest.
Please let me know ASAP as I am in touch with other
Sincerely,
banks.
Bruce Lets analyze this loan arrangement
Sincerely,
Yael. 20
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Analyzing the Deal
Time t=0 Time t=1
Yael founder of SKY High Valuation of $1,400,000 (prob. half)

Holds equity (worth?) Yael’s payoff $875,000
Bruce’s payoff $525,000
Bruce from Star Bank Low Valuation of $900,000 (prob. half)

$ ,
Holds debt worth $500,000 Yael’s payoff $375,000
.
John’s payoff $525,000
What is the current value
of Yael’s equity?
21
Calculating the Value of Yale’s Levered Equity
Valuation
The expected value of SKY Equity in one year at time t=1:
𝐸 𝐸𝑞𝑢𝑖𝑡𝑦 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡 1
1 1
$875,000 $375,000 $𝟔𝟐𝟓, 𝟎𝟎𝟎
2 2
The PV at time t=0 of SKY’s Equity:
$625,000 What is wrong in this

𝑃𝑉 $543,000 ? valuation of SKY’s Equity?
1.15
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SKY’s (Market) Balance Sheet

Assets
What was wrong in

our analysis?
23
Modigliani and Miller
Capital Structure Irrelevance Theorem
Revisiting SKY’s Balance Sheet
What is the Conclusion here?
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Irrelevance Theorem
Capital Structure and Firm Value
Modigliani and Miller (1958) argued In a perfect capital market the total value of the firm is
equal to the market value of the total cash flows generated by its assets and is not affected by
its choice of capital structure.

By Perfect Capital Markets
they referred to markets
Value of Assets 𝑉 𝑈 𝐸 𝐷 Value Debt
without transaction costs,
taxes, bankruptcy costs,
Value of Unlevered Equity Value of Equity
information asymmetries and
any other friction.
25
Levered Equity as a Plug-Number
Capital Structure and Firm Value
We can calculate the value of the levered equity held by Yael by using the
MM irrelevance theorem
Value of Assets 𝑉 𝑈 𝐸 𝐷 Value Debt Let’s look again at the

$1 million $500,000
Market Balance Sheet
Value of Unlevered Equity Value of Levered Equity

$1 million
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Revisiting SKY’s (Market) Balance Sheet

Assets
From the MM theorem we

know the value of Yael’s
equity position
27
Fixing SKY’s (Market) Balance Sheet
Assets Liabilities
Debt =0
Present Value of Market value of
SKY’s future CFs from traded securities
Debt
business operations
$500,000
Value of SKY
The next step is revisit our earlier
$1,000,000 Yael’s Equity
(wrong) calculation of $543,000 for
$500,000
?
Yael’s Equity to better understand
what went wrong
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What is the Conclusion here?
Let’s go back to the Present Value calculation for the value of Yael’s (levered) equity.
$625,000 Does the risk of the return on

𝑃𝑉 $543,000
1.15 equity change with leverage?
Now that we know that the value of equity must be $500,000, what can we say about the
equity cost of capital? Let’s briefly examine the risk of
Yael’s return on equity
$625,000
𝑃𝑉 $500,000 → 𝑟 25%
?????
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Return Volatility and Leverage
All Equity Firm Let’s Compare this to the case of debt

financing
The value of Equity at time t=0 :
𝐸 $1 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
The value of Equity at time t=1:
𝑏𝑎𝑑 𝑠𝑡𝑎𝑡𝑒 𝐸 $900,000 𝐸 $1,400,000 𝑔𝑜𝑜𝑑 𝑠𝑡𝑎𝑡𝑒
10% 0% 40% 30
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Return Volatility and Leverage
Levered Firm Notice the higher risk involved with

levered equity
The value of Equity at time t=0 :
𝐸 $500,000
The value of Equity at time t=1:
𝐸 $375,000 𝑏𝑎𝑑 𝑠𝑡𝑎𝑡𝑒 𝑔𝑜𝑜𝑑 𝑠𝑡𝑎𝑡𝑒 𝐸 $875,000
25% 10% 0% 40% 75% 31
Expected Returns Inacross

part B wethe Balance
will delve Sheet
deeper into how leverage changes the
debt and equity cost of capital
Assets Liabilities
Debt =0
Debt Return on Debt:

Expected Return on
Value of SKY $500,000 𝑟 5%
Assets:
𝑟 15% $1,000,000 Equity Expected Return on Equity:
$500,000
? 𝑟 25%
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Wrapping up
Acquittance with debt and equity securities
Perfect capital markets
Capital Structure Irrelevance theorem
Part B: continue to discuss capital structure

and risk of debt and equity securities.
33
17

Ch 14 Part a Leverage Risk and Return

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3/30/2023

Leverage, Firm Value, and Risk| Chapter 14 Prof. Nisan Langberg

Leverage, Firm Value and Risk (Part A)

Funding Alternatives The Sky Venture (Equity

The Sky Venture (Debt Modigliani and

Leverage, Firm Value, and Risk| Chapter 14 Prof. Nisan Langberg

Agenda for this Unit

Cash Flow versus Control Rights

Leverage, Firm Value, and Risk| Chapter 14 Prof. Nisan Langberg

Fixed Income (debt)

Leases and Asset-backed bonds Convertible debt

Lines of Credit and Bank Loans

Leverage, Firm Value, and Risk| Chapter 14 Prof. Nisan Langberg

Preferred Shares Royalty financing

Convertible Preferred Shares

Leverage, Firm Value, and Risk| Chapter 14 Prof. Nisan Langberg

Control Rights Cash Flow Rights

Elect board of directors Dividend payments

Coupon and principal payments

Leverage, Firm Value, and Risk| Chapter 14 Prof. Nisan Langberg

Financing and Business Decisions

Financing decisions Business decisions

Take a loan Develop new product How are business and

Repurchase shares Reduce production

Refinance loans Sell a division

Leverage, Firm Value, and Risk| Chapter 14 Prof. Nisan Langberg

Optimal Capital Structure

Cost of Equity Capital 𝒓𝑬

The expected annual return demanded by debt

Leverage, Firm Value, and Risk| Chapter 14 Prof. Nisan Langberg

Cross Industry Look

$9 $0.34 $0.04 $3.25

Leverage, Firm Value, and Risk| Chapter 14 Prof. Nisan Langberg

Funding Sky with Equity

Agenda for this Unit

Yael’s Startup SKY

Approaching IC VC for Equity

SKY’s Market Balance Sheet

Leverage, Firm Value, and Risk| Chapter 14 Prof. Nisan Langberg

The Investment Opportunity

Is this a good investment opportunity?

Leverage, Firm Value, and Risk| Chapter 14 Prof. Nisan Langberg

The expected value of SKY in one year at time t=1:

𝐸 𝐶𝐹 $1,400,000 $900,000 $𝟏, 𝟏𝟓𝟎, 𝟎𝟎𝟎

So…is this a good investment

Leverage, Firm Value, and Risk| Chapter 14 Prof. Nisan Langberg

The Funding Dilemma

Yael can approach a debt investor (bank) and

Leverage, Firm Value, and Risk| Chapter 14 Prof. Nisan Langberg

Yael approaches John from IC Venture Capital (Equity)

Dear John, Dear Yael,

Leverage, Firm Value, and Risk| Chapter 14 Prof. Nisan Langberg

Yael approaches John IC Venture Capital (Equity)

Leverage, Firm Value, and Risk| Chapter 14 Prof. Nisan Langberg

Analyzing the Deal

Yael founder of SKY High Valuation of $1,400,000 (prob. half)

John from IC VC Low Valuation of $900,000 (prob. half)

Leverage, Firm Value, and Risk| Chapter 14 Prof. Nisan Langberg

Calculating the Expected Return on Equity for IC VC

$700,000 𝑜𝑟 40% 𝑟𝑒𝑡𝑢𝑟𝑛 𝑝𝑟𝑜𝑏. ℎ𝑎𝑙𝑓

$450,000 𝑜𝑟 10% 𝑟𝑒𝑡𝑢𝑟𝑛 𝑝𝑟𝑜𝑏. ℎ𝑎𝑙𝑓

YES John breaks even!

Leverage, Firm Value, and Risk| Chapter 14 Prof. Nisan Langberg

SKY’s (Market) Balance Sheet