Corporate Financial Management

Week of March 12th -16th, 2018

Corporate Finance Theory and its extensions

Dr. Philippe Versijp, Finance group

Room M3.03
p.j.p.m.versijp@uva.nl

Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 1/23

 Program :
• Modigliani & Miller: perfect markets
• Levering returns and betas
• Modigiliani & Miller: proposition II
• Signalling
• Agency problems

Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 2/23

 Modigliani & Miller: prop 1
• Up to now, we focussed on the tools of corporate finance and
their practical limitations.
• To realise when these tools may not be applicable, or are
missing important elements, we also need to place them in a
theoretical framework. Modigliani & Miller provide this
through 2 propositions.

• MM proposition 1: In a perfect capital market, the total value

of a 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.

• This leads to two questions: what is a perfect capital market,

and what are the consequences of MM prop 1?
Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 3/23
 A(n) (im)perfect capital market (1)
• The conditions for a perfect capital market are:
– Everyone trades securities at competitive prices, equal to the NPV of the
expected future cash flows
– There are no taxes, transaction costs, issuance costs and the like.
– Financing decisions do not affect cash flows, nor do they reveal information
about them.
• In other words: every violation of these conditions will create a
difference between financing through debt or equity. We’ve seen
this already in case of taxes.
• Transaction costs, issuance costs and non-competitive trading will
hurt the arbitrage mechanism, so that market prices cannot be
readily used. In the first two cases the discrepancy – and
therefore the consequences – are usually small. Non-competitive
capital markets lie outside the area discussed in this course.
Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 4/23
 A(n) (im)perfect capital market (2)
• This leaves the third condition: “Financing decisions do not affect cash
flows, nor do they reveal information about them.” We’ve seen that
taxes influence cash flows to equity and debt; the new
elements are in the second half of the condition: financing
decisions can serve as signals.

• Before we can see how that works, we need to summarize the

situation we compare with (that is, when MM’s perfect capital
markets are indeed there)

• This recaps much of what we studied in weeks 1-4 in a single

slide:

Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 5/23

 Levering returns and betas
• In a perfect capital market, the asset side of the balance sheet
is where all the action is. The liability side only divides the
returns, and the risk (and does so by means of leverage).
• As always, total returns and total risk have to be equal on both
sides of the balance sheet, so we can calculate – and compare –
the situation when there is no leverage (or any other D/D+E
ration, but no leverage is a natural point for comparison)
• Finally, return is a function of beta, so these 2 sets of equations
hold (ignoring taxes):
D E D E
rA = rU = rD + rE β A = βU = βD + βE
D+E D+E D+E D+E
D D
rE = rU + (rU − rD ) β E = βU + ( βU − β D )
E E
Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 6/23
 Modigliani & Miller: prop 2
• Which leads to a follow-up called “Modigliani & Miller proposition
2”: The cost of capital of levered equity increases with the firm’s
market value debt-equity ratio.

• The reason for this is that equity, like any type of capital, requires
a reward matching its risk. Leverage increases the risk, as it
increases the variance on equity (same amount of risk is spread of
a smaller amount of capital):
– Suppose we have all equity financing, worth 100, and CFs of either 80 or
160 with equal probability. Expected return is 20%, variance of the returns
is 0.16.
– Suppose we have the same CFs for the assets, but with 60 in debt and 40 in
equity. CFs to equity are 20 or 100, giving returns on equity of -50% and
+150%, for a variance of 1.0. This higher risk (assuming it’s not
diversifiable) means a higher return (in this case +50%) is required.

Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 7/23

 Consequences for capital structure
• If everything depends on the real assets (their cash flows and how
much undiversifiable risk they contain) and we can always trade
securities, leverage may affect the returns and the betas (even
without default, high leverage creates higher variance on equity,
so a higher rE and βE), but any investor can undo those effects.
• The anser is ‘homemade leverage’: if you want more, buy a stock,
but partially fund it with debt (so the investor borrows money),
and you have pay-offs/returns which are identical to if the
company had more leverage.

• This is the intuition behind MM prop 1 & 2: in perfect markets,

you can replicate any desired level of leverage. Now we move
back to imperfect markets.

Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 8/23

 Consequences of default in imperfect
markets (1)
• We’ve already discussed that a higher leverage ratio can increase
the probability of default (not honoring your obligations) and
even bankruptcy (the next step, where litigation is involved, and
often liquidation).

• The primary mechanism for this, is that the value of the assets
drop below the value of the liabilities (excluding equity, which has
no rights on assets in such a situation).

• In reality, default is often triggered by a shortage of liquidity. The

value may still be there, but it’s tied up in other assets, while cash
is what’s needed to settle any obligations.

Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 9/23

 Consequences of default in imperfect
markets (2)
• In a perfect capital market, this effect wouldn’t exist –
banks/investors would recognize the value locked in the assets,
and provide additional capital to refinance the debt.

• The owners of debt realise as well that markets aren’t perfect, so

they see an increase in leverage – an increase in obligations – as a
signals that the likelihood of problems (i.e. default) increases,
even before the value of the assets starts approaching the value
of the debt. Financial distress is also a value-destroying situation.

• This holds doubly true since there are ‘bankruptcy costs’; as soon
as the firm is rumoured to be in poor shape, cash flows suffer:

Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 10/23

 Consequences of default in imperfect
markets (3)
• Bankruptcy rumors drive any customers (especially for products
where warranty / post sale service is important.
• Suppliers will want to be paid in advance, or refuse to ship goods
at all. Getting your money from a defaulted company can be hard,
slow and costly – potentially pushing suppliers into default too.
• Employees will look for jobs elsewhere
• Receivables or assets may sell for lower prices

• All of these factors will enter rD and rE as soon as they are

expected. This means that equity values suffer too – in fact, if the
existence of such costs is the only imperfection, equity would
bear it all, as those costs would be part of the calculations before
default actually happens.

Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 11/23

 Agency costs (1)
• The cost of financial distress isn’t the only issue where leverage
may have different effects than MM predict.
• There might also be agency costs. Agency conflicts arise when the
persons taking the decisions are different from those who bear
the (financial) consequences of that decision.
• There might be agency conflicts between debt- and equity
holders, and between equity holders and the management.

• Three classical examples of conflicts between debt-holders and

equity-holders are: over leveraging a company, asset substitution
and debt overhang.

Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 12/23

 Conflicts of interest: leverage
• The first problem we could encounter is related to the amount
of debt. More debt can be good for the shareholders : it is
cheap capital and has a tax advantage. But adding debt can
decrease the value of existing loans.
Balance sheet “Deluge Inc” Balance sheet “Deluge Inc”

Assets: Liabilities: Assets: Liabilities:

- All 20 - Equity 10 - All 20 - Equity 2
- Debt 10 - New debt 8
- Old debt 10

• But suppose the company does poorly, and is left with 16 to

pay out. Barring covenants, all debt holders get 16/18 = 89% of
their value, while in that situation the debt used to be secure!

Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 13/23

 Conflicts of interest: asset substitution
• The second problem concerns adding risk: suppose that before
we had assets that would give a value (later) of 22 or 18.
Balance sheet “All-in Inc” Balance sheet “All-in Inc”

Assets: Liabilities: Assets: Liabilities:

22 7 30 14
-All or - Equity or -All or - Equity or
18 2 12 0
- Debt 16 16
- Debt or
12
• In the first situation, the debt is not risky, there will be enough
value to repay it. But in the second setup… The expected value
for the shareholders does increase though!
• NB: this can happen even if the assets are less valuable than
the original ones! (its the spread in values that counts)
Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 14/23
 Conflicts of interest: debt overhang
• The third problem concerns lack of cash when the company
faces financial distress. Say we add a project that increases the
assets by 5 with certainty. But the company has so much debt
(18), it won’t get any loans and can only emit new equity.
Balance sheet “Strike Inc” Balance sheet “Strike Inc”

Assets: Liabilities: Assets: Liabilities:

30 12 35 17
-All or - Equity or -All or - Equity or
10 0 15 0
18 18
- Debt or - Debt or
10 15
• There’s no point for the shareholders to fund the investment,
as there’s a good chance the proceeds go to the debt holders!
Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 15/23
 Agency costs (2)
• Asset substitution and debt overhang could also mean that
positive NPV projects are ignored (especially if the value in the
future might fall below the level of debt obligations, and
management is better informed), or that negative NPV projects
are undertaken (this could benefit the shareholders if the variance
of a negative NPV project is such that there is a chance that it will
pay off big, and therefore something will be left for shareholders
after all)

• Those lending money to the company will try to prevent this kind
of behavior through provisions in the debt contract (a.k.a.
covenants)

Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 16/23

 Agency costs (3)
• There could also be agency costs related to a misalignment of
interests between the manager and shareholders: some projects
might have a negative NPV for the company, but a positive value
for the managers.
• While gold-plated headquarters and corporate jets are the most
colorful examples of these costs, the problem tends to be at its
worst if a company grows beyond the range where it can create
value. Mergers and acquisitions can be a costly example of
managerial overreach that is not in the interest of shareholders.
• In this case, leverage is a mechanism to reduce agency costs. If a
company has a substantial amount of debt to service, it becomes
harder to fund reckless acquisitions and other expenses. Due to
the potential for debt-equity agency costs, debt will include
covenants to limit manager’s freedom of action.

Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 17/23

 Agency costs (4)
• Agency costs become more relevant when there is assymetric
information. If one party (debt, equity, managment) knows
more than the others, there will be an incentive to exploit this
information.
• The other parties may not know what this information is, but
they will probably know that the assymetry exists. This will be
priced as well, leading to lower values (due to the higher risk).
A credible way to get this information across to the other
parties is therefore valuable.
• Issuing equity can, for example, be seen as a signal in this way:
it may indicate the stock is overvalued (managment thinks its a
good idea to issue equity), or even that no loans could be
obtained (pecking order theory). Therefore, announcements of
equity issues tend to cause drops in share value.

Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 18/23

 Intermezzo: pecking order theory
• Pecking order theory suggest that companies who wish to invest
obtain their capital:
– First from internal sources; the easiest is simply retaining profits.
As slashing dividends is a strong negative signal, the prudent course of
action is making sure enough capital is retained even if not directly needed.
– Should this be insufficient, a bank loan or even a bond issue will be
contemplated. Less risky securities are used, as this is a signal that someone
trusts the company’s plans and perceives them as good value. As it is easier
to reduce information assymetry with a bank, and/or a bonds can contain
numerous covenants, debt would be the instrument of choice after
internally raised capital
– Only when risk is very high, or no loans can be obtained, will one go for an
equity issue.
• If the market believes this theory, it becomes a kind of self-fulfilling
prophecy: issuign equity will be seen as a negative signal, and
therefore cause price drops, and thus become unpopular with
managment.

Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 19/23

 Agency costs (5)
• Therefore, decisions that influence leverage tend to be timed, if at
all possible: announce it quickly after (unrelated) good news has
become known, or when reports have been made public, so the
assymetry is reduced.

• Taking on more debt can also be a signal that reduces asymmetric

information: it may indicate confidence from the part of
managment. (or alternatively, it may indicate one of the debt-vs.-
equity rachtes we saw earlier. The same action might therefore be
interpreted very differently by the markets, depending on which
explanation they find more credible).

Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 20/23

 Course evaluation
• Please take out your laptops/tablets/phones (yes, I said that!)
and....
Complete the questionnaire with the course evaluation.

• Each of you should have received a personal email (from

a.vangorp@uva.nl) with a link. This was sent out (by automated
system) on Sunday.

• Course Evaluation results are used by lecturers, course

coordinators, programme directors and UvA education
management to improve the courses you have taken (and are
about to follow) at UvA Economics and Business.

Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 21/23

 The rich field of corporate finance (1)
• The conclusion is therefore that, in reality, markets are imperfect,
and that financial decisions – most prominently the amount of
leverage – do matter.

• Imperfections can and will impact rD and rE. How much is unclear,
but signalling, agency costs, assymetric information (to name the
major ones) can all interact with leverage.

• It is therefore likely that there comes a point where – for a specific

company – the capital structure is optimal. This is the trade-off
theory. In its simplest form it adds the PV of the tax shield and
subtracts the PV of the financial distress costs, more elaborate
versions include agency and singalling effects too.

Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 22/23

 The rich field of corporate finance (2)
• In the end, markets will value these aspects in setting rD and rE.
• Yet corporate Finance is based on the numbers, but how to
properly discount cash flows and realize value is not just a
mechanical exercise: capital markets are in the end a combination
of human decisions.

• You now have the necessary toolkit to take and judge those
decisions.

• Good luck with the exam! Keep visiting the discussion board!

Corporate Financial Management Lecture 6 – 12/3 & 16/3 ’18 23/23