Transcript Slide 1

EXP 482
Corporate Financial Policy
Clifford W. Smith, Jr.
Winter 2007
*covers Miller (1988) and Smith (1979) on reading list.
Course Description
An Historical Perspective
 Before 1950
Heavily institutional, largely normative
Ad hoc, lacked any systematic scientific basis
 1950s to 1970s
Focus shifted to positive analysis
Almost all analysis in context of perfect capital markets
 Since mid 1970s
Developed a set of analytical tools that allowed systematic
analysis of contracting costs and the contracting process
Fundamental Building Blocks
of Modern Finance
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Portfolio Theory
EXP 481

Asset Pricing Theory

Option Pricing Theory
Agency Theory

The structure of contracts
EXP 444

Individual incentives

Efficient Markets Theory
–
–
Fundamental Building Blocks
of Modern Finance
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
Capital Budgeting
 EXP 480
– Corp. Investment Policy
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Capital Structure
Compensation Policy
Leasing Policy
Hedging Policy
Dividend Policy
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 EXP 482
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Readings
Chew – The New Corporate Finance: Where
Theory Meets Practice
Brealey & Myers – Principles of Corporate
Finance
Brickley/Smith/Zimmerman – Managerial
Economics and Organizational Architecture
Grading
 Several homework assignments (25%)
 Midterm exam on January 26 (20%)
 Class participation (5%)
 A final exam on March 16 (50%)
Selected Financial Variables
Leverage
(%)
Dividend
(%) Yield
CEO
Salary
Long-Term
Comp.
Delta
22
2
672
719
Dupont
16
4
1,474
1,272
H.P.
7
1
1,250
1,440
Merck
1
1
2,340
4,223
Pacific
36
10
999
473
The Modigliani/Miller Theorem
 If
There are no taxes.
There are no contracting costs.
The firm's investment policy is fixed.
 Then
The value of the firm is independent of its
financing policy.
A Quick Lesson on Logic
If A then B
Implies
If not B then not A
Modigliani/Miller II
 If the choice of capital structure affects
current firm value, then it does so by:
– Changing tax liabilities
– Changing contracting costs
– Changing investment incentives
Proof of the
Modigliani/Miller Theorem*
* Attributed to Yogi Berra
“
N
obody
goes
there anymore. It’s too
crowded.”
I was talking to Stan Musial and Joe
Garagiola in 1959 about Ruggeri’s
restaurant in my old neighborhood in
St. Louis. It was true!
Yogi Berra
“
W
e’re
lost, but
we’re making
good
time!”
Casey Stengel & Yogi Berra, 1972
I said this on the way to the Hall of Fame in
Cooperstown in 1972. My wife, Carmen, and my
sons, Larry, Tim and Dale, were all in the car.
hard to believe it, but I got lost. Carmen was
giving me a hard time, so I gave it back.
Yogi Berra
“
A
lways
go to other
people’s funerals,
otherwise they
won’t go to yours.”
Mickey and I had been talking
about all the funerals we’d been to
in that year. We were saying that
pretty soon there would be no one
left to come to ours.
Yogi Berra
When asked if I wanted my pizza cut into
four or eight slices, I replied:
“Four. I don’t think
I can eat eight.”
Yogi Berra
An Option Pricing Application
D
E
V= E+D
Valuing Debt and Equity
of a Levered Firm
f(V*)
Consider a Simple Firm:
V*
D*
E*
F
F
F
V*
V*

Fixed investment policy

One bond issue

No coupons

Single maturity date

Face value = F
Valuing Debt and Equity
of a Levered Firm
f(V*)
Consider a Simple Firm:
V*
D*
E*
F
F
F
V*
V*

Fixed investment policy

One bond issue

No coupons

Single maturity date

Face value = F
Valuing Debt and Equity
of a Levered Firm
f(V*)
Consider a Simple Firm:
V*
D*
E*
F
F
F
V*
V*

Fixed investment policy

One bond issue

No coupons

Single maturity date

Face value = F
Valuing Debt and Equity
of a Levered Firm
 There are other securities that have the same
payoff structure as the equity of a levered firm.
 One such security is a call option
 Since we know something about how options are
priced, we can use this information to learn
something about the value of debt and equity in a
levered firm.
Black/Scholes Model
Comparative Statics
C = C (S, X, T, s², r, DIV)
The Value of a Call Option
At Expiration
C*
X
S*
The Value of a Call Option
Prior to Expiration
C
e-rT X X
S
An Option Pricing Application
D*
V*
F
E*
V*
F
Think about the equity
of the firm as
a call option on the
assets of the firm, with
maturity date T, and
exercise price F
An Option Pricing Application
V= E+D
D
E
V = E(V, F, T, σ², r, DIV)
+ D(V, F, T, σ², r, DIV)
A Slightly More
Complicated Example
What will happen to the value the debt and
equity of the firm if the firm takes a project that
has a positive NPV, and lowers the variance of
the future firm value?
dD = (∂D/∂V) dV + (∂D/∂σ²) dσ²
dE = (∂E/∂V) dV + (∂E/∂σ²) dσ²
Junior and Senior Debt
E*
V*
V = E (V, Fs, Fj, T, σ², r, DIV )
F(s)
F(s)+F(j)
D(j)
+ Dj (V, Fs, Fj, T, σ², r, DIV )
V*
F(s)
F(s)+F(j)
D(s)
+ Ds (V, Fs, Fj, T, σ², r, DIV)
V*
F(s)
F(s)+F(j)
Why Senior Bondholders Care
About the Issuance of Junior Debt
 The legal system and absolute
priority
 Priority in time
Consider a Bond
that Pays Coupons
Time
V = E (V, F, C1, C2 ... CT, T1, T2 ... TT, σ², r, DIV)
+ D (V, F, C1, C2 ... CT,T1, T2 ... TT, σ², r, DIV)
Convertible Bonds
A convertible bond gives the owner the
right to exchange the bond for common
stock. Suppose the entire bond issue can
be exchanged for some fraction a of the
common stock.
Convertible Bonds
E*
(1-a)V*
V = E(V, F, a, T, σ², r, DIV)
V*-F
V*
F F/a
CB*
aV*
+ CB(V, F, a, T, σ², r, DIV)
F
V*
F
F/a
V*
Many Bonds Have Other
Imbedded Options
Consider a bond that gives the bondholder
the option to be paid either in cash or in silver
at maturity. Other things equal, is this bond
worth more if it is issued by a user of silver
(like Kodak) or by a producer of silver (a
mining company)?
Many Bonds Have Other
Imbedded Options
For a bond with a silver delivery option
D = D[ . . . σs², ρ(v,s)]
Firm Value
Low
High
Silver Prices
Low
High
Investment Policy Involves
Imbedded Options
 R&D
 Flexibility
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