EXP 482Corporate Financial Policy

Clifford W. Smith, Jr.Winter 2007

*covers Miller (1988) and Smith (1979) on reading list.

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

Course Description

Fundamental Building Blocksof Modern Finance

Efficient Markets Theory

Portfolio Theory

Asset Pricing Theory

Option Pricing Theory

Agency Theory

– The structure of contracts

– Individual incentives

EXP 481

EXP 444

Fundamental Building Blocksof Modern Finance

Capital Budgeting– Corp. Investment Policy

Capital Structure Compensation Policy Leasing Policy Hedging Policy Dividend Policy

EXP 480

EXP 482

Chew – The New Corporate Finance: Where Theory Meets Practice

Brealey & Myers – Principles of Corporate Finance

Brickley/Smith/Zimmerman – Managerial Economics and Organizational Architecture

Readings

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

CEOSalary

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

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.

The Modigliani/Miller Theorem

A Quick Lesson on Logic

If A then B

Implies

If not B then not A

If the choice of capital structure affects current firm value, then it does so by:

– Changing tax liabilities

– Changing contracting costs

– Changing investment incentives

Modigliani/Miller II

Proof of the Modigliani/Miller Theorem*

* Attributed to Yogi Berra

“ obody goes

there any-more. It’s too crowded.”

N

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

“ e’re lost, but

we’re making good time!”

W

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

Casey Stengel & Yogi Berra, 1972

“ lways go to other

people’s funerals,otherwise theywon’t go to yours.”

A

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

““FourFour. . I don’t think I can eat eight.”

When asked if I wanted my pizza cut into

four or eight slices, I replied:

Yogi Berra

V = E + D

An Option Pricing Application

D

E

Valuing Debt and Equity of a Levered Firm

Consider a Simple Firm: Fixed investment

policy

One bond issue

No coupons

Single maturity date

Face value = F

F

F

F

V*

V*

V*

f(V*)

D*

E*

Valuing Debt and Equity of a Levered Firm

Consider a Simple Firm: Fixed investment

policy

One bond issue

No coupons

Single maturity date

Face value = F

F

F

F

V*

V*

V*

f(V*)

D*

E*

Valuing Debt and Equity of a Levered Firm

Consider a Simple Firm: Fixed investment

policy

One bond issue

No coupons

Single maturity date

Face value = F

F

F

F

V*

V*

V*

f(V*)

D*

E*

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.

Valuing Debt and Equity of a Levered Firm

Comparative Statics

C = C (S, X, T, ², r, DIV)

Black/Scholes Model

The Value of a Call Option At Expiration

C*

S*X

The Value of a Call Option Prior to Expiration

C

SXe X-rT

An Option Pricing Application

FV*

E*

FV*

D* 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

D

E

V = E + D

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

F(s)

F(s)

F(s)

V*

V*

V*

E*

D(j)

D(s)

F(s)+F(j)

F(s)+F(j)

F(s)+F(j)

V = E (V, Fs, Fj, T, σ², r, DIV )

+ Dj (V, Fs, Fj, T, σ², r, DIV )

+ Ds (V, Fs, Fj, T, σ², r, DIV)

Why Senior Bondholders CareAbout 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)

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 of the common stock.

Convertible Bonds

Convertible Bonds

F

FV*

V*

E*

CB*

V*F

V*

V*-F

V = E(V, F, , T, σ², r, DIV)

+ CB(V, F, T, σ², r, DIV)

F/

F/

(1-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)]

Silver Prices Low High

Fi

rm V

alu

eH

igh

Low

Investment Policy Involves Imbedded Options

R&D

Flexibility

This article is in hard copy handout