Modigliani-Miller Model MM have a convincing argument that a firm cannot change the total value of its outstanding securities

s by changing the proportions in the capital structure. This means that the value of the firm is the same under different capital structures. Assumptions of the Modigliani-Miller Model are:

1. Homogeneous Expectations 2. Homogeneous Business Risk Classes 3. Perpetual Cash Flows 4. 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 The MM Proposition I (No Taxes) Firm value is not affected by leverage VL = VU The MM Propositions II (No Taxes) 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 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 shield rS = 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 debt S is the value of levered equity Conclusion of MM propositions 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

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. LIMITS TO THE USE OF DEBT 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. An increase in debt levels increases the likelihood of financial distress which in its ultimate form is known as bankruptcy. This is a state where ownership of the firms assets is legally transferred from the shareholders to the debt holders. This is coz the debt obligations of the firm are fundamentally different from the shares obligations whereby bondholders are legally entitled to interest and principal re-payments while shareholders are not legally entitled to dividends although they expect it. The possibility of bankruptcy has a negative effect on the value of the firm. 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). Costs of liquidation and re-organization Indirect Costs Impaired ability to conduct business (e.g., lost sales). Bankruptcy hampers the firms conduct with customers and suppliers. Sales are frequently lost coz of both fear of impaired service as well as loss of trust. Agency Costs Agency costs When a firm has debt, conflicts of interest arise btn shareholders and bondholders. These conflicts which are magnified when fin distress is incurred impose agency costs on the firm. The shareholders engage in selfish strategies to hurt the debt holders and protect their own interests and in the process agency costs are incurred which lower the value of the firm. Selfish strategy 1: Incentive to take large risks: firms near bankruptcy often take chances because they believe that they are using someone elses money. Since the debt holders have prior claims to profits and the shareholders only have a claim to the residual, the managers acting in the interests of the shareholders may be tempted to take on riskier projects than they would have done if the firm was unlevered. Selfish strategy 1: Incentive to take large risks Selfish strategy 2: Incentive toward underinvestment Selfish Strategy 3: Milking the property

Selfish strategy 2: Incentive toward underinvestment: shareholders with a significant probability of bankruptcy often find that new inv helps the debt holders at the expense of the shareholders.

Selfish Strategy 3: Milking the property: this strategy involves paying out extra dividends or other distributions in times of fin distress, leaving less in the firm for the debt holders.

These distortions only occur when there is a probability of bankruptcy which in turn is increased by the increase in the use of debt. The costs arising from these distortions are ultimately paid by the shareholders. This is coz the debt holders will require a higher rate of return as the probability of fin distress increases.

Integration of Tax Effects and 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. 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. The Basic Forms of Acquisitions There are three basic legal procedures that one firm can use to acquire another firm: Merger or Consolidation Acquisition of Stock Acquisition of Assets

Varieties of Takeovers Determining the Synergy from an Acquisition Most acquisitions fail to create value for the acquirer. The main reason why they do not lies in failures to integrate two companies after a merger. Intellectual capital often walks out the door when acquisitions aren't handled carefully. Traditionally, acquisitions deliver value when they allow for scale economies or market power, better products and services in the market, or learning from the new firms. Synergy Suppose firm A is contemplating acquiring firm B. The synergy from the acquisition is

Synergy = VAB (VA + VB) The synergy of an acquisition can be determined from the usual discounted cash flow model: Source of Synergy from Acquisitions Revenue Enhancement Cost Reduction Including replacement of ineffective managers. Tax Gains Net Operating Losses Unused Debt Capacity

Incremental new investment required in working capital and fixed assets Two "Bad" Reasons for Mergers

Earnings Growth Only an accounting illusion.

Diversification Shareholders who wish to diversify can accomplish this at much lower cost with one phone call to their broker than can management with a takeover.

Defensive Tactics Target-firm managers frequently resist takeover attempts. It can start with press releases and mailings to shareholders that present managements viewpoint and escalate to legal action. Management resistance may represent the pursuit of self-interest at the expense of shareholders. Resistance may benefit shareholders in the end if it results in a higher offer premium from the bidding firm or another bidder. Divestitures The basic idea is to reduce the potential diversification discount associated with commingled operations and to increase corporate focus, Divestiture can take three forms: Sale of assets: usually for cash Spinoff: parent company distributes shares of a subsidiary to shareholders. Shareholders wind up owning shares in two firms. Sometimes this is done with a public IPO.

 Issuance if tracking stock: a class of common stock whose value is connected to the performance of a particular segment of the parent company. FINANCIAL RISK MANAGEMENT This is mainly concerned with the management of the risk arising from holding or issuing financial securities. The investor or the borrower risks losing if the value of those securities change unfavorably.

i.

The risks include: Default risk: concern by lenders that the borrowers will default on obligations to repay the interest and eventually the principal. This will in turn depend on the nature of the loan as well as credit worthiness of the borrower. Therefore, the higher the risk, the higher the interest rate.

Fin risk management 1. Interest rate risk: relates to the uncertainty about the prevailing market interest rates in the future. The risk here is that the interest charged may be insufficient should economic conditions change drastically after the loan is made. 2. Pre-payment risk: prepayment gives borrowers the opportunity to prepay the loan on residential property without penalty. If this is done when interest rates fall, lenders lose out as compared to what they would have earned as per the original contract. 3. Liquidity risk: this refers to ease or otherwise of liquidating the security whereby the more liquid securities attract lower premiums as compared to the less liquid ones. 4. Legislative risks: refers to changes in the legislative environment that may impact on the premiums charged. This may include legislation affecting taxation of mortgages, rent controls, interest rates etc. Therefore, the following instruments are available to the finance manager to manage those risks.

Options and Corporate Finance: Many corporate securities are similar to the stock options that are traded on organized exchanges. Almost every issue of corporate stocks and bonds has option features. In addition, capital structure and capital budgeting decisions can be viewed in terms of options. Options Contracts An option gives the holder the right, but not the obligation, to buy or sell a given quantity of an asset on (or perhaps before) a given date, at prices agreed upon today. Calls versus Puts Call options gives the holder the right, but not the obligation, to buy a given quantity of some asset at some time in the future, at prices agreed upon today. When exercising a call option, you call in the asset. Put options gives the holder the right, but not the obligation, to sell a given quantity of an asset at some time in the future, at prices agreed upon today. When exercising a put, you put the asset to someone. Exercising the Option The act of buying or selling the underlying asset through the option contract. Strike Price or Exercise Price Refers to the fixed price in the option contract at which the holder can buy or sell the underlying asset. Expiry The maturity date of the option is referred to as the expiration date, or the expiry.

European versus American options European options can be exercised only at expiry. American options can be exercised at any time up to expiry.

In-the-Money The exercise price is less than the spot price of the underlying asset.

At-the-Money The exercise price is equal to the spot price of the underlying asset.

Out-of-the-Money The exercise price is more than the spot price of the underlying asset.

Intrinsic Value The difference between the exercise price of the option and the spot price of the underlying asset.

Speculative Value The difference between the option premium and the intrinsic value of the option.

Forward Contracts A forward contract specifies that a certain commodity will be exchanged for another at a specified time in the future at prices specified today. Its not an option: both parties are expected to hold up their end of the deal. If you have ever ordered a textbook that was not in stock, you have entered into a forward contract.

Futures Contracts A futures contract is like a forward contract: It specifies that a certain commodity will be exchanged for another at a specified time in the future at prices specified today. A futures contract is different from a forward: Futures are standardized contracts trading on organized exchanges with daily resettlement (marking to market) through a clearinghouse. Standardizing Features: Contract Size Delivery Month Daily resettlement Minimizes the chance of default Initial Margin About 4% of contract value, cash or T-bills held in a street name at your brokerage. Hedging Two counterparties with offsetting risks can eliminate risk. For example, if a wheat farmer and a flour mill enter into a forward contract, they can eliminate the risk each other faces regarding the future price of wheat. Hedgers can also transfer price risk to speculators and speculators absorb price risk from hedgers. Speculating: Long vs. Short

Swaps Contracts In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals. There are two types of interest rate swaps: Single currency interest rate swap Plain vanilla fixed-for-floating swaps are often just called interest rate swaps. Cross-Currency interest rate swap This is often called a currency swap; fixed for fixed rate debt service in two (or more) currencies. A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties. The swap bank can serve as either a broker or a dealer. As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap. As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with counterparty.