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EXP 482Corporate Financial Policy
Clifford W. Smith, Jr.Winter 2007
*covers Miller (1988) and Smith (1979) on reading list.
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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
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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
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Fundamental Building Blocksof Modern Finance
Capital Budgeting– Corp. Investment Policy
Capital Structure Compensation Policy Leasing Policy Hedging Policy Dividend Policy
EXP 480
EXP 482
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Chew – The New Corporate Finance: Where Theory Meets Practice
Brealey & Myers – Principles of Corporate Finance
Brickley/Smith/Zimmerman – Managerial Economics and Organizational Architecture
Readings
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Grading
Several homework assignments (25%)
Midterm exam on January 26 (20%)
Class participation (5%)
A final exam on March 16 (50%)
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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
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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
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A Quick Lesson on Logic
If A then B
Implies
If not B then not A
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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
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Proof of the Modigliani/Miller Theorem*
* Attributed to Yogi Berra
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“ 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
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“ 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
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“ 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
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““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
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V = E + D
An Option Pricing Application
D
E
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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*
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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*
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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*
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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
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Comparative Statics
C = C (S, X, T, ², r, DIV)
Black/Scholes Model
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The Value of a Call Option At Expiration
C*
S*X
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The Value of a Call Option Prior to Expiration
C
SXe X-rT
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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
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An Option Pricing Application
D
E
V = E + D
V = E(V, F, T, σ², r, DIV)
+ D(V, F, T, σ², r, DIV)
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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
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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)
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Why Senior Bondholders CareAbout the Issuance of Junior
Debt
The legal system and absolute priority
Priority in time
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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)
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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
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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*
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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)?
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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
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Investment Policy Involves Imbedded Options
R&D
Flexibility
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This article is in hard copy handout