Principles of Corporate Finance

Brealey and Myers Sixth Edition

 An Overview of Corporate
Financing

Chapter 14
343

Patterns of Corporate Financing

Firms may raise funds from external
sources or plow back profits rather than
distribute them to shareholders.
Should a firm elect external financing, they
may choose between debt or equity
sources.
 Distinction between debt & equity

?
 Debt Financing Options
bank loans
bonds,
leasing
352

Corporate Debt
Debt has the unique feature of allowing the
borrowers to walk away from their obligation to pay,
in exchange for the assets of the company.
“Default Risk” is the term used to describe the
likelihood that a firm will walk away from its
obligation, either voluntarily or involuntarily.
 “Bond Ratings”are issued on debt
instruments to help investors assess the default
risk of a firm.
355

Corporate Debt
Prime Rate - Benchmark interest rate charged by
banks.
Funded Debt - Debt with more than 1 year remaining
to maturity.
Sinking Fund - Fund established to retire debt before
maturity.
Callable Bond - Bond that may be repurchased by
firm before maturity at specified call price.
356

Corporate Debt
Secured Debt - Debt that has first claim on specified
collateral in the event of default.
Subordinate Debt - Debt that may be repaid in
bankruptcy only after senior debt is repaid.
Investment Grade - Bonds rated Baa or above by
Moody’s or BBB or above by S&P.
Junk Bond - Bond with a rating below Baa or
BBB.
357

Corporate Debt
Eurodollars - Dollars held on deposit in a bank
outside the United States.
Eurobond - Bond that is marketed internationally.
Protective Covenants - Restriction on a firm to
protect bondholders.
Lease - Long-term rental agreement.
358

Corporate Debt
Convertible Bond - Bond that the holder may
exchange for a specified amount of another security.

Convertibles are a combined security, consisting of

both a bond and a call option.
346

Debt Financing
How do we define debt ?

Debt 997  1391



 .61
LongTotal
termassets
liabilities 3896 1391
  .4
Long term liabilities  1391  8
equity 1508
 Equity Financing Options
• common stock,
• venture capital,
• warrants & rights (will cover in options)
• private placements
348

Common Stock
Book Value vs. Market Value
Book value is a backward looking measure. It
tells us how much capital the firm has raised from
shareholders in the past. It does not measure the
value that shareholders place on those shares
today. The market value of the firm is forward
looking, it depends on the future dividends that
shareholders expect to receive.
349

Common Stock
Example - Mobil Book Value vs. Market Value (12/97)
Total Shares outstanding = 783.4 million

Common Shares ($1 par) 894

Additional paid in capital 1,549
Retained earnings 20,661
Currency adjustment - 821
Treasury shares at cost - 3,158
Net common equity (Book Value) 19,125
350

Common Stock
Example - Mobil Book Value vs. Market Value (12/97)
Total Shares outstanding = 783.4 million

Dec 1997 Market price $72/sh

= x
# of shares
Market Value $56.4783.4
billion
351

Preferred Stock
Preferred Stock - Stock that takes
priority over common stock in
regards to dividends.
Net Worth - Book value of common
shareholder’s equity plus preferred
stock.
Floating-Rate Preferred - Preferred
stock paying dividends that vary with
short term interest rates.
363

Venture Capital
Venture Capital
Money invested to finance a new firm

Since success of a new firm is highly dependent on

the effort of the managers, restrictions are placed on
management by the venture capital company and
funds are usually dispersed in stages, after a certain
level of success is achieved.
364

Venture Capital
First Stage Market Value Balance Sheet ($mil)
Assets Liabilities and Equity
Cash from new equity 1.0 New equity from venture capital 1.0
Other assets 1.0 Your original equity 1.0
Value 2.0 Value 2.0
365

Venture Capital

Second Stage Market Value Balance Sheet ($mil)

Assets Liabilities and Equity
Cash from new equity 4.0 New equity from 2nd stage
Fixed assets 4.0
Other 1.0 Equity from 1st stage
5.0
assets
9.0 Your original equity
Value
5.0
14.0 Value 14.0
 Private Placement
- Sale of securities to a limited number of investors
without a public offering.
 Principles of Corporate Finance
Brealey and Myers Sixth Edition

 Does Debt Policy Matter?

Chapter 17
407

Topics Covered
Leverage in a Tax Free
Environment
How Leverage Affects Returns
The Traditional Position
408

M&M (Debt Policy Doesn’t Matter)

Modigliani & Miller
€ When there are no taxes and capital markets
function well, it makes no difference whether the
firm borrows or individual shareholders borrow.
Therefore, the market value of a company does
not depend on its capital structure.
409

M&M (Debt Policy Doesn’t Matter)

Assumptions
By issuing 1 security rather than 2, company
diminishes investor choice. This does not
reduce value if:
€ Investors do not need choice, OR
€ There are sufficient alternative securities
Capital structure does not affect cash flows e.g...
€ No taxes
€ No bankruptcy costs
€ No effect on management incentives
410

M&M (Debt Policy Doesn’t Matter)

Example - Macbeth Spot Removers - All Equity
Financed
Data
Number of shares 1,000
Price per share $10
Market Value of Shares $ 10,000

Outcomes
A B C D
Operating Income $500 1,000 1,500 2,000 Expected
Earnings per share $.50 1.00 1.50 2.00 outcome
Return on shares (%) 5% 10 15 20
411

M&M (Debt Policy Doesn’t Matter)

Example Data
Number of shares 500
cont.
Price per share $10
50% debt Market Value of Shares $ 5,000
Market value of debt $ 5,000

Outcomes
A B C D
Operating Income $500 1,000 1,500 2,000
Interest $500 500 500 500
Equity earnings $0 500 1,000 1,500
Earnings per share $0 1 2 3
Returnon shares (%) 0% 15 25 30
412

M&M (Debt Policy Doesn’t Matter)

Example - Macbeth’s - All Equity Financed
- Debt replicated by investors

Outcomes
A B C D
Earnings on two shares $1.00 2.00 3.00 4.00
LESS : Interest @ 10% $1.00 1.00 1.00 1.00
Net earnings on investment $0 1.00 2.00 3.00
Return on $10 investment (%) 0% 10 20 30
413

No Magic in Financial
Leverage
MM'S PROPOSITION I
If capital markets are doing their job,
firms cannot increase value by tinkering
with capital structure.

V is independent of the debt ratio.

AN EVERYDAY ANALOGY

It should cost no more to assemble a

chicken than to buy one whole.
414

Proposition I and Macbeth

Macbeth continued

Cuttent Structure: Proposed Structure :

All Equity Equal Debt and Equity
Expected earnings per share 1.50 2.00
($)
Price per share ($) 10 10
Expected return per share (%) 15 20
415

Leverage and Returns

Expected return on assets  expected operating income

a  market value of all
r
securities

D E
rA    rD     rE 
   
DE DE
416

M&M Proposition II
Macbeth continued
D
rE  rA 
V
rA  rD


expected operating income

r E  rA 
market value of all
1500securities
 10,00  .1
5
0
417

M&M Proposition II
D Macbeth continued
rE  rA 
V
rA  rD
 expected operating income
rE  rA 
market val ue of all
securities
 10,00  .1
1500 5
0

5000
rE  .15 
5000
 .15
 .10  .20 or
20%
419

Leverage and Risk

Macbeth continued
Leverage increases the risk of Macbeth shares
Operating Income
$500 $1,500
All Earnings per share .50 1.50
equity ($) Return on shares 5 15
50 % Earnings per share 0 2
debt : ($) Return on shares 0 20
420

Leverage and Returns

D E 
BA    BD     BE 
   
DA DE

D
BE  BA 
V
BA  BD

421

WACC
 WACC is the traditional view of
capital structure, risk and return.

D  E
WACC  rA    r D     r E 
V V
 Practice
Ms. Kraft owns 50,000 shares of the common stock of
Copperhead Corporation with a market value of $2 per
share, or $100,000 overall. The company is currently
financed as follows:

Copperhead now announces that it is replacing $1 million

of short-term debt with an issue of common stock. What
action can Ms. Kraft take to ensure that she is entitled to
exactly the same proportion of profits as before?
 Practice
Spam Corp. is financed entirely by common stock and has a beta of
1.0. The firm is expected to generate a level, perpetual stream of
earnings and dividends. The stock has a price– earnings ratio of 8
and a cost of equity of 12.5%. The company’s stock is selling for
$50. Now the firm decides to repurchase half of its shares and
substitute an equal value of debt. The debt is risk-free, with a 5%
interest rate. The company is exempt from corporate income taxes.
Assuming MM are correct, calculate the following items after the
refinancing:
Requirements:
• The cost of equity.
• The overall cost of capital (WACC).
• The price–earnings ratio.
• The stock price.
• The stock’s beta.
 Practice Questions
The common stock and debt of Northern Sludge are valued
at $50 million and $30 million, respectively. Investors
currently require a 16% return on the common stock and an
8% return on the debt. If Northern Sludge issues an
additional $10 million of common stock and uses this
money to retire debt, what happens to the expected return
on the stock? Assume that the change in capital structure
does not affect the risk of the debt and that there are no
taxes.
 Home Assignment
Solve the following questions: Q4, 6, 8 of chapter 17

Read Chapter 18 for next class.