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Copyright 2002 by Prentice Hall Inc. All rights reserved.
Prentice Hall
2-1

Prentice Hall
2-2
C H A P T E R 2
Valuation and Financing
Decisions in an Ideal Capital
Market
Prentice Hall
2-3
Assumptions of the Ideal Capital Market
Assumption 1: Capital Markets are Frictionless
(i.e., no taxes or transaction costs).
Assumption 2: All Market Participants Share
Homogeneous Expectations.
Assumption 3: All market participants are
atomistic.
Assumption 4: The Firms Investment Program is
Fixed and Known.
Assumption 5: The Firms Financing is Fixed.
Prentice Hall
2-4
Modigliani and Millers (M&M)
Proposition I
M&M Proposition I: The market value of a
firm (V) is invariant to the amount of leverage
[i.e., debt (D) relative to equity (E)] used to
finance its assets.
Proof is based on an arbitrage argument. If V
U

E
U
=V
L
D+E
L
does not hold for a given firm, an
arbitrageur can purchase the firm (or a portion of
it), alter its capital structure, and then sell it for an
immediate profit.
Prentice Hall
2-5
M&M Proposition II: The expected return on
a firms equity increases with the firms
leverage.
This is a corollary to Proposition I. The value of a
firm can remain invariant to changes in capital
structure only if the firms Weighted Average Cost
of Capital (WACC), which is the discount rate
used to determine the value of the firms assets, is
constant as leverage varies
Modigliani and Millers (M&M)
Proposition II
Prentice Hall
2-6
implies both equations below (for a given firm)
t tan cons
E D
E
r
E D
D
r r WACC
L
L
LE
L
D A
=
(
+
+
(
+
= =
) r r (
E
D
r r
D A
L
A LE

(
+ =
Prentice Hall
2-7
A Numerical Example
Firm Z is currently an all-equity firm with V
U
E
U
=$100,
and r
A
r
UE
=10%.
Firm Z recapitalizes by issuing debt with a value of
D=$35, using the proceeds to pay a dividend to stockholders.
The value of firm Z remains $100: V
L
D+E
L
=$35+$65.
Stockholders are indifferent to the change because they
maintain $100 in value: $35 in dividends and $65 in stock.
If the cost of debt capital is r
D
=7%, then the cost of
levered equity is:

% 62 . 11 %) 7 % 10 (
65
35
% 10 r
LE
=
(
+ =
Prentice Hall
2-8
Dividends are also Irrelevant in an Ideal
Capital Market
If a firms investment and debt policy are
fixed, then as the firm increases its dividend, it must
eventually finance such payments by issuing additional
shares. However, a dividend is just a partial liquidation of
the original shareholders interest in the firm. Hence, a
dividend and the simultaneous issuance of new shares (at a
fair market price) is just a forced sale of a portion of the
original shareholders claim on the firm to new
shareholders. But this sale occurs at a fair market price, so
it is a matter of indifference to all parties, including the
original shareholders who can, if they wish, use their
dividend cash to restore their proportional claim on the
firm by purchasing some of the issued shares.
Prentice Hall
2-9
Modern Portfolio Theory
MPT involves two basic constructs:
the statistical effects of diversification on the expected
return and risk of a portfolio; and
the attitudes of investors toward risk; specifically, it is
assumed that investors are averse to risk, but are
sufficiently tolerant of risk to bear it if sufficient
compensation (i.e., higher expected return), is provided.
MPT assumes that investors are concerned only
with the expected return and standard deviation of
their overall portfolio. MPT addresses the task of
identifying the portfolio that maximizes an
investors expected utility given the investors
willingness to tradeoff risk and expected return.
Prentice Hall
2-10
Statistics for a Portfolio of Two Securities
Expected return:
r
p
= w
A
r
A
+ w
B
r
B

Example: r
A
=10%; r
B
=15%; w
A
=.7;

w
B
=.3
r
p
= 0.7(10%)+0.3(15%)=11.5%
Standard deviation:

Example: o
A
=30%; o
B
=50%;
AB
=0.33; w
A
=.7
o
p
=[0.7
2
30
2
+0.3
2
50
2
+2(0.7)(0.3)(30)(50)(0.33)]
1/2
=29.6%
| |
2 / 1
AB B A B A
2
B
2
B
2
A
2
A p
w w 2 w w o o + o + o = o
Prentice Hall
2-11
Statistics for an N-Security Portfolio
Expected return (general)

Expected return (equally weighted)

Standard deviation (general)

Standard deviation (equally weighted)

=
=
N
1 i
i i p
r w r
=
=
N
1 i
i p
r
N
1
r

o = o
= =
N
1 i
N
1 j
2 / 1
ij j i p
] w w [
, )] ( * )
N
1
1 ( ) ( *
N
1
[
2 / 1
ij
2
i p
o + o = o
Prentice Hall
2-12
FIGURE 2-1 Annual Return Standard Deviation, o
p
, for an Equally-
Weighted Portfolio as a Function of the Number of Risky Securities in
the Portfolio, N, for Alternative Values of the Average Pairwise
Correlation () Between the Securities' Returns
0
5
10
15
20
25
30
35
40
45
1 2 3 4 5 7 10 15 20 30 40 55 70 100 150 225 300 450
Number of Securities (N)
o
p

(
%
)
= 0.10
= 0.50
= 0.25
Prentice Hall
2-13
Prentice Hall
2-14
Prentice Hall
2-15
In the CAPM equilibrium, all investors hold
the market portfolio, which includes all risky
assets (each held in proportion to its relative
outstanding total market value), in
combination with the risk-free asset.
The details of an individual investors complete
portfolio (C) can be described using the Capital
Market Line (CML).
The expected return on an individual security is a
function of its systematic risk, measured by |
(beta). This relationship is the Security Market
Line (SML).
The Capital Asset Pricing Model (CAPM)
Prentice Hall
2-16
The Capital Asset Pricing Model (CAPM)
The Capital Market Line (CML):

The Security Market Line (SML):

) r r ( r r
f M
M
c
f c

(
o
o
+ =
) r r ( r r
f M i f i
| + =
Prentice Hall
2-17
The Binomial Pricing Model
Assumed distribution of future stock price:
With u>1:
With d=1/u:
A useful formula for u:
With: V=firm value; and p=prob. of an up jump:

uV V
u
T
=
dV V
d
T
=
T
e u
o
=
(
(

+
(
(

=
V
V V
) p 1 (
V
V V
p r
d
T
u
T
A
Prentice Hall
2-18
Payoff on default-risky debt of a levered firm:
If up jump:
If down jump:
Payoff on default-risky levered equity:
If up jump:
If down jump:
X D
u
T
=
X V D
d
T
d
T
< =
X V E
u
T
u
LT
=
0 E
d
LT
=
Prentice Hall
2-19
We can value the firms equity and debt by
creating a riskfree hedge portfolio with a long
position in the levered firms assets and a short
position in o units of the firms levered equity.
The value of o must be chosen so that the
portfolio has the same payoff in both the up
and down states:
] E V [ ] E V [
d
LT
d
T
u
LT
u
T
o = o
Prentice Hall
2-20
The value of the equity of a levered firm:
Given hedge ratio:
the value of the equity is:
d
LT
u
LT
d
T
u
T
E E
V V
= o
T
f
u
LT
u
T L
) r 1 /( E
1
V ]
1
[ V E +
(

|
.
|
\
|
o
o
=
Prentice Hall
2-21
The Put-Call Parity Theorem
By arbitrage, the following relationship must
hold among the value of an underlying asset
(V), the values of put (P) and call (C) options
on the underlying asset that share the same
exercise price (X) and expiration date (T), and
the present value of a risk-free pure-discount
bond that pays the amount X at date T:
V+P=C+X/(1+r
f
)
T
Prentice Hall
2-22
The Black-Scholes Option Pricing Model
Assumption: The underlying assets
instantaneous returns are normally
distributed with constant per-annum
mean and standard deviation of o.
The equity of a levered firm is a call
option on the firms assets, where X, the
promised payment on pure-discount
debt, is the exercise price, and the time to
expiration of the call option is T, the time
to maturity of the debt.
Prentice Hall
2-23
The formula is:

where N(d) is the cumulative normal
distribution function and:
The Black-Scholes Option Pricing Model
T
T )] 2 / ( r [ )
X
V
( ln
d
2
f
o
o + +
=
)] T d ( N [ X e )] d ( N [ V C
T
f
r
o =

Prentice Hall
2-24
FIGURE 2-4 The Distribution of IBM's Monthly Stock Returns,
1980-2000
0
2
4
6
8
10
12
14
16
18
-26-24-22-20-18-16-14-12-10-8 -6 -4 -2 0 2 4 6 8 10121416182022242628
Return (%, Integer Categories)
F
r
e
q
u
e
n
c
y
0%
1%
2%
3%
4%
5%
6%
N
o
r
m
a
l

D
i
s
t
r
i
b
u
t
i
o
n

P
r
o
b
a
b
i
l
i
t
y

D
e
n
s
i
t
y

(
%
)
Mean (1.21%)
Std. Deviation (7.56%)
Normal
Distribution

Prentice Hall
2-25
FIGURE 2-5 Annual Return Standard Deviations for the Equity (o
EL
)
and Debt (o
D
) of a Levered Firm, and Market Debt Ratio, D/V, all as
Functions of the Promised Payment, X, on 5-Year Pure-Discount Debt.
(Standard deviation of assets is o=20%.)
0%
20%
40%
60%
80%
100%
120%
140%
0 50 100 150 200 250 300
X
o
LE
o
o
D
D/V
Prentice Hall
2-26
FIGURE 2-6 Combinations of Leverage (D/V) and Asset Standard
Deviation (o) Yielding Standard Deviations of 1%, 5%, 10%, and 20%
for the Firm's 5-Year Pure Discount Debt
0%
20%
40%
60%
80%
100%
0% 20% 40% 60% 80% 100%
o
D/V
o
D
=1%
o
D
=5%
o
D
=20%
o
D
=10%
Prentice Hall
2-27
FIGURE 2-7 An Illustration of a Firm-Specific Security Market Line
0%
5%
10%
15%
20%
25%
30%
35%
0% 20% 40% 60% 80% 100% 120%
Annual Return Standard Deviation
A
n
n
u
a
l

E
x
p
e
c
t
e
d

R
e
t
u
r
n
Debt (X=50)
Debt (X=90)
Assets
Equity (X=50)
Equity (X=90)

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