Choices of Finance.

• Internal or External.

• External: Debt or Equity.

• Statistic of Debt/Equity ratio.

• Question: Is a high ratio bad?

Does financial planning matter?

• Practitioneers devote a lot of attention to it. Leverage. Dividend policy.

• D/E in Cement industry is 20 times D/E ratio in Pharmaceuticals. Why?

• What are the important issues?

Clientele Theory

• Also called financial marketing.• Investors with heterogeneous preferences and

needs value the same cash flow streams differently.

• Financial policy choices affect the match between the security and clientele.

• Therefore, financial policy affects the firm’s value!!

For instance, an all-equity firm may fail to exploit the demands for both riskier and safer securities.

M&M (Debt Policy Doesn’t Matter)

• Modigliani & Miller (MM 1:Debt Irrelevance)– 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.

M&M (Debt Policy Doesn’t Matter)

Assumptions• Frictionless and competitive markets.• Individuals can take same financial transactions as

the firms and at same cost.• The firms’ financing and operating decisions are

independent.• Capital structure does not affect cash flows e.g...

– No taxes– No bankruptcy costs– No effect on management incentives

M&M intuition

• Idea was revolutionary in the 50’s (won them the Nobel Prize).

• Investors’ preferences are over cash flows not securities.

• If they can make the same transactions as firms at the same prices, they will not pay a premium for firms to take such transactions.

• Put differently, if investors can reverse the firms’ financial decisions, these decisions are immaterial.

Arbitrage Proof.

• Two firms: V1=D1+E1, V2=E2.• Both generate random X from same distribution.• Firm 1 debt holders receive r * D1.• Firm 1 equity holders receive X-r*D1.• Firm 2 equity holders receive X• If V2>V1, it is profitable to sell E2 and buy V1.• If V1>V2, it is profitable to sell E1 (borrow D1)

and buy V2.

M&M thoughts

• Yogi Berra said "You better cut the pizza in four pieces because I'm not hungry enough to eat six."

• A dairy farmer cannot make more money by skimming some of the butter fat and selling it and skim milk separately even though the butter fat sells for a higher prices per kg than whole milk.

Other applications.

• Applies to Governments as well (taxes or borrowing)!

• Modigliani, F. and M. Miller "Corporate Income Taxes and the Cost of Capital" American Economic Review, June 1963, 433-443.

• Miller, M., "Debt and Taxes," Journal of Finance, June 1977, 32, 261-276.

MMII (Leverage Irrelevance)

• Interest rate on corporate debt was 5%. Stock market averages 11%. How can financing be irrelevant?

• When debt is risk free, the expected return on common stock increases linear to the D/E ratio

)( debtassetsassetsequity rrE

Drr

Proof of MMII

[ ]a d e

E X D Er r r

V D E D E

Rearranging yields

( )e a d a

Dr r r r

E

Taxes and Bankruptcy

• Interest is tax deductible so savings is

t* Rd * D. Present value is t*Rd*D/ Rd.– Vl is value of leveraged firm,– Vu is value of unleveraged firm– Vl=Vu+t*D – Re=Ru+(Ru-Rd)*(D/E)*(1-t)

Financial Distress

Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy. (Enron has over a billion direct costs).

Market Value = Value if all Equity Financed

+ PV Tax Shield

- PV Costs of Financial Distress

Financial Distress

Debt

Mar

ket V

alue

of

The

Fir

m

Value ofunlevered

firm

PV of interesttax shields

Costs offinancial distress

Value of levered firm

Optimal amount of debt

Maximum value of firm

Is this really true (Miller 1977)?

• Bankruptcy costs are not that high.

• If income tax rate is progressive: higher income, more taxes.

• Then general equilibrium effects will cause rates such that the corporate tax shield is equal to the personal income tax.

• This means that the MM results return!!

Pecking Order Hypothesis

• Managers know more than outside investors.• This explains why a new issue lowers the price

(they wouldn’t do it if they felt the stock was undervalued).

• Firms prefer internal financing in order not to send adverse signals that may lower the stock price.

• If external financing is required, they issue debt first and then equity in order to avoid this bad signal.

Trade-off Theory

• The optimal D/E structure depends upon the trade-off between interest tax shields and what financial troubles are out there.

• Companies with safe, tangible assets ought to have high D/Es.

• Companies with risky, intangible assets ought to rely on equity.

• Highly profitable firms sometimes don’t take on debt, like MSFT, JNJ but GE has 4.25

Financial Slack

• Financial Slack is valuable in order to let bond holders feel that the bonds are risk free.

• Financial Slack may have a cost in that financial distress gives strong incentives for managers (especially entrenched ones) to work their butts off.

Moral hazard.

• What happens if all assets are not in place?• Switching to a riskier project is

advantageous to share-holders.• Why? On plus side, bond holders don’t

gain, but loose more on the minus side since chance of default goes up.

• May invest in Negative NPV projects!!• Does convertible bonds help alleviate this?

JB

• JB Manufacturing is an all equity firm. The equity is worth £2 million. The cost (return) of equity is 18%. JB pays no taxes. JB plans on issuing £400,000 in debt and use the proceeds to repurchase equity. The cost (return) of debt is 10%.

• What will the cost of capital (return on assets) be after repurchase?

• What will the return of equity be?

Market Efficiency

Efficient Capital Markets - Financial markets in which security prices rapidly reflect all relevant information about asset values.

Market Efficiency Theory

Capital markets reflect all relevant information. You cannot consistently earn excess profits.

Random Walk - Security prices change randomly, with no predictable trends or patterns.

Random Walk Theory

• The movement of stock prices from day to day DO NOT reflect any pattern.

• Statistically speaking, the movement of stock prices is random (skewed positive over the long term).

Random Walk Theory

$103.00

$100.00

$106.09

$100.43

$97.50

$100.43

$95.06

Coin Toss Game

Heads

Heads

Heads

Tails

Tails

Tails

Market Efficiency

Technical Analysts - Investors who attempt to identify over- or undervalued stocks by searching for patterns in past prices.

Fundamental Analysts - Analysts who attempt to fund under- or overvalued securities by analyzing fundamental information, such as earnings, asset values, and business prospects.

Once a profit making opportunity is discovered, it will be competed away.

Market Efficiency

Weak Form Efficiency - Market prices rapidly reflect all information contained in the history of past prices.

Semi-Strong Form Efficiency - Market prices reflect all publicly available information.

Strong Form Efficiency - Market prices reflect all information that could in principle be used to determine true value.

Todd’s trip to work

• Two paths to work: Beit Oren and Hof Carmel.• There is construction on the Beit Oren path

starting on Sunday.• Weak form of travel efficiency, after a day or so

paths will take the same time.• Semi-Strong form, if announced beforehand, that

day paths will take the same time.• Strong form, as long as one of the city planners

know, that day paths will take the same time.

Lessons of Market Efficiency

• Markets have no memory

• Trust market prices

• There are no financial illusions

• Do it yourself diversification (worry about transaction costs).

Markets are good at aggregating information.

• Experiment by Charles Plott.• State of world is either X, Y or Z.• A stock has highest value in state Z and

lowest in X. • Bidders are given different signals. For

instance if state Z half are given not X and half Y.

• Miracle: Price of stock went to actual value.

Prediction Markets

• Began with Iowa electronic presidential market.

• Used then at HP.• Now Google uses it. • Also there is intrade and tradesports.• Tried to use it for Terrorism.• Read Wisdom of Crowds if you are

interested.

Prediction Markets

• People have taken market efficiency in reverse.

• If markets are efficient then they reflect information available.

• If we want to find out this information, run a market..

Market now.

• We are going to run a presidential prediction market (for fun)..

• Asset X will pay 100 shekels if Obama wins and 0 shekels otherwise.

• Asset Y will pay 100 shekels if McCain wins and 0 otherwises.

• Even teams will start with 5 of asset X, odd teams will start with 5 of asset Y.

• Both teams will start with 500 shekels endowment..