finance class 07-8
DESCRIPTION
FinanceTRANSCRIPT
Capital Market
Markets for raising and investing long-term finance
An organised and regulated market place in which raisers of capital and capital investors can come together
Serve two main purposes Primary markets enable organisations to raise new finance, by issuing new shares or new
debentures make it easier for companies to raise new long-term finance than if they had to raise funds
privately
Secondary markets they enable existing investors to sell their investments A shareholder in a 'listed' company can sell his shares whenever he wants to on the Stock
Exchange.
Most trading of stocks and shares on the capital markets is in existing securities, rather than new issues.
Over the counter (OTC) markets
refer to stocks that trade via a dealer network as opposed to on a centralized exchange
traded over-the-counter is usually because the company is small, making it unable to meet exchange listing requirements.
Instruments such as bonds do not trade on a formal exchange and are, therefore, also considered OTC securities
Stock market vs exchange
A stock exchange is a formal stock market, with a central location (stock exchange building), systems for trading in shares, rules of conduct, and systems for disseminating information to investors London Stock Exchange
Dhaka Stock Exchange
A stock market is a more general term for an organised market in securities, but without a central stock exchange building. NASDAQ- A global electronic marketplace for buying and selling securities
Fundamental vs Technical Analysis
Technical analysis looks at the price movement of a security and uses this data to predict its future price movements method of evaluating securities by analyzing the statistics generated by market activity
a technical analyst approaches a security from the charts
Fundamental analysis, on the other hand, looks at economic factors, known as fundamentals to predict its future price movements By looking at the balance sheet, cash flow statement and income statement, a
fundamental analyst tries to determine a company's value
'EFFICIENT MARKET HYPOTHESIS - EMH' According to the EMH, stocks always trade at their fair value on stock exchanges,
making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices.
Description of Efficient Capital Markets
An efficient capital market is one in which stockprices fully reflect available information.
The EMH has implications for investors and firms.Since information is reflected in security prices quickly,
knowing information when it is released does an investorno good.
Firms should expect to receive the fair value for securitiesthat they sell. Firms cannot profit from fooling investors inan efficient market.
Reaction of Stock Price to New Information in Efficient and Inefficient Markets
Stock Price
-30 -20 -10 0 +10 +20 +30Days before (-) and after
(+) announcement
Efficient market response to “good news”
Overreaction to “good news” with reversion
Delayed response to “good news”
Reaction of Stock Price to New Information in Efficient and Inefficient Markets
Stock Price
-30 -20 -10 0 +10 +20 +30
Days before (-) and after (+) announcement
Efficient market response to “bad news”
Overreaction to “bad news” with reversion
Delayed response to “bad news”
The Different Types of Efficiency
Weak Form Security prices reflect all information found in past prices and
volume.
Semi-Strong Form Security prices reflect all publicly available information.
Strong Form Security prices reflect all information—public and private.
Weak Form Market Efficiency
Security prices reflect all information found in past prices and volume.
If the weak form of market efficiency holds, then technical analysis is ofno value.
Often weak-form efficiency is represented as
Pt = Pt-1 + Expected return + random error t Since stock prices only respond to new information, which by definition
arrives randomly, stock prices are said to follow a random walk.
It will be impossible to identify patterns of share price movements andshare price trends
Why Technical Analysis FailsSt
ock
Pric
e
Time
Investor behavior tends to eliminate any profit opportunity associated with stock price patterns.
If it were possible to make big money simply by finding “the pattern” in the stock price movements, everyone would do it and the profits would be competed away.
Sell
Sell
Buy
Buy
Semi-Strong Form Market Efficiency
Security Prices reflect all publicly availableinformation.
Publicly available information includes: Historical price and volume information
Published accounting statements.
Information found in annual reports.
It will not be possible for investors to make a speculative gainon the basis of publicly-available information.
Strong Form Market Efficiency
Security Prices reflect all information—public and private.
Strong form efficiency incorporates weak and semi-strong form efficiency.
Strong form efficiency says that anything pertinent to the stock and known to at least one investor is already incorporated into the security’s price.
Making profits from insider dealing would not be possible
Relationship among Three Different Information Sets
All informationrelevant to a stock
Information setof publicly availableinformation
Informationset ofpast prices
Why EMH is important for managers? If the markets display weak form efficiency, the share price will not respond
immediately to announcements about the expected future profitability of new investment projects.
If the market displays semi-strong form efficiency, announcements by management about the future profitability of new investments will affect the share price.
If the market displays strong form efficiency, the share price will respond to events before they are publicly announced.
The Capital-Structure Questionand The Pie Theory The value of a firm is defined to be the sum of the value of the firm’s debt and the
firm’s equity.
V = B + S
If the goal of the management of the firm is to make the firm as valuable as possible, the thefirm should pick the debt-equity ratio that makes the pie as big as possible.
Value of the Firm
S BS BS BS B
The Capital-Structure QuestionThere are really two important questions:1. Why should the stockholders care about maximizing firm
value? Perhaps they should be interested in strategies that maximize shareholder value.
2. What is the ratio of debt-to-equity that maximizes the shareholder’s value?
As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases.
Financial Leverage, EPS, and ROE
CurrentAssets $20,000Debt $0Equity $20,000Debt/Equity ratio 0.00Interest rate n/aShares outstanding 400Share price $50
Proposed$20,000$8,000
$12,0002/38%
240$50
Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.)
EPS and ROE Under Current Capital Structure
Recession Expected ExpansionEBIT $1,000 $2,000 $3,000Interest 0 0 0Net income $1,000 $2,000 $3,000
EPS $2.50 $5.00 $7.50ROA 5% 10% 15%ROE 5% 10% 15%
Current Shares Outstanding = 400 shares
EPS and ROE Under Proposed Capital Structure
Recession Expected ExpansionEBIT $1,000 $2,000 $3,000Interest 640 640 640Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83ROA 5% 10% 15%ROE 3% 11% 20%
Proposed Shares Outstanding = 240 shares
EPS and ROE Under Both Capital Structures
LeveredRecession Expected Expansion
EBIT $1,000 $2,000 $3,000Interest 640 640 640Net income $360 $1,360 $2,360EPS $1.50 $5.67 $9.83ROA 5% 10% 15%ROE 3% 11% 20%Proposed Shares Outstanding = 240 shares
All-EquityRecession Expected Expansion
EBIT $1,000 $2,000 $3,000Interest 0 0 0Net income $1,000 $2,000 $3,000EPS $2.50 $5.00 $7.50ROA 5% 10% 15%ROE 5% 10% 15%Current Shares Outstanding = 400 shares
Financial Leverage and EPS
(2.00)
0.00
2.00
4.00
6.00
8.00
10.00
12.00
1,000 2,000 3,000
EPS
Debt
No Debt
Break-even point
EBIT in dollars, no taxes
Advantage to debt
Disadvantage to debt
Assumptions of the Modigliani-Miller Model Homogeneous Expectations Homogeneous Business Risk Classes Perpetual Cash Flows Perfect Capital Markets:
Perfect competition Firms and investors can borrow/lend at the same rate Equal access to all relevant information No transaction costs No taxes
Homemade Leverage: An ExampleRecession Expected Expansion
EPS of Unlevered Firm $2.50 $5.00 $7.50
Earnings for 40 shares $100 $200 $300Less interest on $800 (8%) $64 $64 $64Net Profits $36 $136 $236ROE (Net Profits / $1,200) 3% 11% 20%
We are buying 40 shares of a $50 stock on margin. We get the same ROE as if we bought into a levered firm.Our personal debt equity ratio is:
32
200,1$800$
SB
Homemade (Un)Leverage:An Example
Recession Expected ExpansionEPS of Levered Firm $1.50 $5.67 $9.83
Earnings for 24 shares $36 $136 $236Plus interest on $800 (8%) $64 $64 $64Net Profits $100 $200 $300ROE (Net Profits / $2,000) 5% 10% 15%
Buying 24 shares of an other-wise identical levered firm along with the some of the firm’s debt gets us to the ROE of the unlevered firm.This is the fundamental insight of M&M
The MM Propositions I & II (No Taxes)
Proposition I Firm value is not affected by leverage
VL = VU
Proposition II Leverage increases the risk and return to stockholders
rs = r0 + (B / SL) (r0 - rB)rB is the interest rate (cost of debt)
rs is the return on (levered) equity (cost of equity)
r0 is the return on unlevered equity (cost of capital)
B is the value of debt
SL is the value of levered equity
The MM Proposition I (No Taxes)
ULVV
BrEBITB
receivefirmleveredain Shareholders
BrB
receiveBondholders
The derivation is straightforward:
BrBrEBITBB
)(
isstakeholdersalltoflowcash totaltheThus,
The present value of this stream of cash flows is VL
EBITBrBrEBITBB
)(
Clearly
The present value of this stream of cash flows is VU
The MM Proposition II (No Taxes)The derivation is straightforward:
SBWACC rSB
SrSB
Br
0set Then rrWACC
0rr
SB
Sr
SB
BSB
S
SB by sidesboth multiply
0rSSBr
SBS
SSBr
SBB
SSB
SB
0rSSBrr
SB
SB
00 rrS
Brr
S
BSB
)( 00 BS rrSBrr
The Cost of Equity, the Cost of Debt, and the Weighted Average Cost of Capital: MM Proposition II with No Corporate Taxes
Debt-to-equity Ratio
Cos
t of c
apita
l: r (
%)
r0
rB
SBW ACC rSB
SrSB
Br
)( 00 BL
S rrSBrr
rB
SB
The MM Propositions I & II(with Corporate Taxes)
Proposition I (with Corporate Taxes)Firm value increases with leverage
VL = VU + TC B
Proposition II (with Corporate Taxes)Some of the increase in equity risk and return is offset by interest
tax shieldrS = r0 + (B/S)×(1-TC)×(r0 - rB)
rB is the interest rate (cost of debt)rS is the return on equity (cost of equity)r0 is the return on unlevered equity (cost of capital)B is the value of debtS is the value of levered equity
The MM Proposition I (Corp. Taxes)
BTVV CUL
)1()(
receivefirmleveredain rsShareholde
CB TBrEBIT BrB
receivesBondholder
BrTBrEBIT BCB )1()(
isrsstakeholdealltoflowcash totaltheThus,
The present value of this stream of cash flows is VL
BrTBrEBIT BCB )1()(Clearly
The present value of the first term is VU
The present value of the second term is TCB
BrTBrTEBIT BCBC )1()1(
BrBTrBrTEBIT BCBBC )1(
The MM Proposition II (Corp. Taxes)Start with M&M Proposition I with taxes:
)()1( 00 BCS rrTSBrr
BTVV CUL
Since BSVL
The cash flows from each side of the balance sheet must equal:
BCUBS BrTrVBrSr 0
BrTrTBSBrSr BCCBS 0)]1([Divide both sides by S
BCCBS rTSBrT
SBr
SBr 0)]1(1[
BTVBS CU
)1( CU TBSV
Which quickly reduces to
The Effect of Financial Leverage on the Cost of Debt and Equity Capital with Corporate Taxes
Debt-to-equityratio (B/S)
Cost of capital: r(%)
r0
rB
)()1( 00 BCL
S rrTSBrr
SL
LCB
LW ACC r
SBSTr
SBBr
)1(
)( 00 BL
S rrSBrr
Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes
All-EquityRecession Expected Expansion
EBIT $1,000 $2,000 $3,000Interest 0 0 0EBT $1,000 $2,000 $3,000Taxes (Tc = 35% $350 $700 $1,050
Total Cash Flow to S/H $650 $1,300 $1,950Levered
Recession Expected ExpansionEBIT $1,000 $2,000 $3,000Interest ($800 @ 8% ) 640 640 640EBT $360 $1,360 $2,360Taxes (Tc = 35%) $126 $476 $826Total Cash Flow $234+640 $468+$640 $1,534+$640(to both S/H & B/H): $874 $1,524 $2,174EBIT(1-Tc)+TCrBB $650+$224 $1,300+$224 $1,950+$224
$874 $1,524 $2,174
Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes
The levered firm pays less in taxes than does the all-equity firm.
Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.
G S G
B
All-equity firm Levered firm
S
Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes
The sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.
This is how cutting the pie differently can make the pie larger: the government takes a smaller slice of the pie!
S G S G
B
All-equity firm Levered firm
Summary: No Taxes In a world of no taxes, the value of the firm is unaffected by capital
structure. This is M&M Proposition I:
VL = VU
Prop I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage.
In a world of no taxes, M&M Proposition II states that leverage increases the risk and return to stockholders
)( 00 BL
S rrSBrr
Summary: Taxes
In a world of taxes, but no bankruptcy costs, the value of the firm increases with leverage.
This is M&M Proposition I:VL = VU + TC B
Prop I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage.
In a world of taxes, M&M Proposition II states that leverage increases the risk and return to stockholders.
)()1( 00 BCL
S rrTSBrr
Prospectus: Bankruptcy Costs
So far, we have seen M&M suggest that financial leverage does not
matter, or imply that taxes cause the optimal financial structure to be
100% debt.
In the real world, most executives do not like a capital structure of 100%
debt because that is a state known as “bankruptcy”.
Costs of Financial Distress
Bankruptcy risk versus bankruptcy cost.
The possibility of bankruptcy has a negative effect on the value of thefirm.
However, it is not the risk of bankruptcy itself that lowers value.
Rather it is the costs associated with bankruptcy.
It is the stockholders who bear these costs.
Description of Costs
Direct Costs Legal and administrative costs (tend to be a small percentage of firm value).
Indirect Costs Impaired ability to conduct business (e.g., lost sales)
Agency Costs Selfish strategy 1: Incentive to take large risks
Selfish strategy 2: Incentive toward underinvestment
Selfish Strategy 3: Milking the property
Can Costs of Debt Be Reduced?
Protective Covenants
Debt Consolidation: If we minimize the number of parties, contracting costs fall.
Protective Covenants
Agreements to protect bondholders Negative covenant: Thou shalt not:
Pay dividends beyond specified amount.Sell more senior debt & amount of new debt is limited.Refund existing bond issue with new bonds paying lower
interest rate.Buy another company’s bonds.
Positive covenant: Thou shall:Use proceeds from sale of assets for other assets.Allow redemption in event of merger or spinoff.Maintain good condition of assets.Provide audited financial information.
Integration of Tax Effectsand Financial Distress Costs There is a trade-off between the tax advantage of debt and the costs of
financial distress.
It is difficult to express this with a precise and rigorous formula.
Integration of Tax Effectsand Financial Distress Costs
Debt (B)
Value of firm (V)
0
Present value of taxshield on debt
Present value offinancial distress costs
Value of firm underMM with corporatetaxes and debt
VL = VU + TCB
V = Actual value of firmVU = Value of firm with no debt
B*
Maximumfirm value
Optimal amount of debt
The Pie Model Revisited Taxes and bankruptcy costs can be viewed as just another
claim on the cash flows of the firm. Let G and L stand for payments to the government and
bankruptcy lawyers, respectively. VT = S + B + G + L
The essence of the M&M intuition is that VT depends on the cash flow of the firm; capital structure just slices the pie.
S
G
B
L
Signaling
The firm’s capital structure is optimized where the marginal subsidy to debt equals the marginal cost.
Investors view debt as a signal of firm value. Firms with low anticipated profits will take on a low level of debt. Firms with high anticipated profits will take on high levels of debt.
A manager that takes on more debt than is optimal in order to fool investors will pay the cost in the long run.
The Pecking-Order Theory
Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient. Rule 1
Use internal financing first.Rule 2
Issue debt next, equity last.
The pecking-order Theory is at odds with the trade-off theory: There is no target D/E ratio.Profitable firms use less debt.Companies like financial slack
Growth and the Debt-Equity Ratio
Growth implies significant equity financing, even in a worldwith low bankruptcy costs.
Thus, high-growth firms will have lower debt ratios than low-growth firms.
Growth is an essential feature of the real world; as a result,100% debt financing is sub-optimal.
How Firms Establish Capital Structure
Most Corporations Have Low Debt-Asset Ratios.Changes in Financial Leverage Affect Firm Value.
Stock price increases with increases in leverage and vice-versa; this is consistent with M&M with taxes.
Another interpretation is that firms signal good news whenthey lever up.
There are Differences in Capital Structure AcrossIndustries.
There is evidence that firms behave as if they had atarget Debt to Equity ratio.
Factors in Target D/E Ratio
Taxes If corporate tax rates are higher than bondholder tax rates, there
is an advantage to debt. Types of Assets
The costs of financial distress depend on the types of assets the firm has.
Uncertainty of Operating IncomeEven without debt, firms with uncertain operating income have
high probability of experiencing financial distress.Pecking Order and Financial Slack
Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.
Summary and ConclusionsCosts of financial distress cause firms to restrain their
issuance of debt.Direct costs
Lawyers’ and accountants’ fees Indirect Costs
Impaired ability to conduct businessIncentives to take on risky projectsIncentives to underinvestIncentive to milk the property
Three techniques to reduce these costs are:Protective covenantsRepurchase of debt prior to bankruptcyConsolidation of debt
Summary and Conclusions Because costs of financial distress can be reduced but not
eliminated, firms will not finance entirely with debt.
Debt (B)
Value of firm (V)
0
Present value of taxshield on debt
Present value offinancial distress costs
Value of firm underMM with corporatetaxes and debt
VL = VU + TCB
V = Actual value of firmVU = Value of firm with no debt
B*
Maximumfirm value
Optimal amount of debt
Summary and Conclusions
Debt-to-equity ratios vary across industries. Factors in Target D/E Ratio
Taxes If corporate tax rates are higher than bondholder tax rates, there is an
advantage to debt.
Types of Assets The costs of financial distress depend on the types of assets the firm has.
Uncertainty of Operating Income Even without debt, firms with uncertain operating income have high
probability of experiencing financial distress.
