Corporate Finance- II

Corporate Finance
• People have been running business for
thousands of years.

• Corporate Finance is few decades old.

• Principles of Corporate Finance are

commonsense and have changed very little over
time.

• It tried to provide some structures, mainly on

detailing.
 Corporate Finance-II
• Maximizing Value
– Investment Decisions
– Financing Decisions
– Valuation of Levered Firms
– Dividend Decisions

• Applications
– Short Term Financial Management
– Leasing
– Mergers and Acquisitions
– Derivatives
– Others
 Evaluation
– Quiz / Exercise
– Comprehensive Tests at Session 5 and 10
– Mid Term
In every session, one quiz /exercise will be taken based on the contents discussed in
the class. You have to answer the quiz correctly to get marks.

Scores obtained in above tests may be considered as mid term

Capital Structure: Basic Concepts
 Value of the Firm

• 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
• The goal of the management
of the firm is to make the firm
as valuable as possible, the S B
firm should pick the debt-equity
ratio that makes the pie as big
as possible.
• What is the ratio of debt-to-
equity that maximizes the
shareholder’s value? Value of the Firm
 The Capital-Structure Question
Your Company having assets of Rs.8000 has no debt in its capital
structure (an unlevered company), issued 400 shares each
values Rs. 20 in the market.
The company has now proposed to issue a 10% per annum debt
instrument of Rs 4000 to buyback 50% of the share issued
(becomes a levered company).
1. Compare the EPS of unlevered and levered company taking ROA
levels of 5%, 15% and 25%.
2. Compare the following strategy of an investor, who wants to invest
Rs. 2000 in the company
Strategy A : Buy 100 shares of levered company with own money
Strategy B : Buy 200 shares of unlevered company borrowing Rs. 2000 at
10% interest.
3. Your friend have invested in your unlevered company to control your
risk. But you have decided to issue Rs. 4000 debt to buy back some
shares and becomes a levered company. What advice can be given
to your friend so that his risk can be reduced?
 Earning-EPS Graph

10

6
EPS

0
0 500 1000 1500 2000 2500
Earnings before interest
Unlevered Levered
Your friend have invested in your unlevered company to control your risk. But
you have decided to issue Rs. 4000 debt to buy back some shares and
becomes a levered company. What advice can be given to your friend so that
his risk can be reduced?
Your friend have invested in your unlevered company to control your risk. But
you have decided to issue Rs. 4000 debt to buy back some shares and
becomes a levered company. What advice can be given to your friend so that
his risk can be reduced?

Self made un-levering

 The Modigliani-Miller Model without
Corporate Taxes
• Modigliani and Miller argued that the value of the firm, and
therefore value of stockholders, would not be affected by
financial leverage.

• They showed that investors could duplicate the same

earnings by borrowing/lending on their own regardless of
the firm’s financial leverage.
 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
 The Modigliani-Miller Model without
Corporate 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)
• r 0 is the return on unlevered equity (cost of capital)
• B is the value of debt
• SL is the value of levered equity
 Returns
“Bond 10%, Equity 15%”
 MM Proposition II with
Cost of capital: r (%) No Corporate Taxes

B
rS  r0   (r0  rB )
SL

B S
r0 rW ACC   rB   rS
BS BS

rB rB

B
Debt-to-equity Ratio S
• Rayburn Manufacturing, Inc., is currently an all-equity
firm that pays no taxes. The market value of the firm's
equity is $2 million. The cost of this unlevered equity is
18 percent per annum. Rayburn plans to issue $400,000
in debt and use the proceeds to repurchase stock. The
cost of debt is 10 percent per annum.
– a. After Rayburn repurchases the stock, what will the firm's
weighted average cost of capital be!
– b. After the repurchase, what will the cost of equity be! Explain.
– c. Use your answer to (b) to compute Rayburn's weighted
average cost of capital after the repurchase. Is this answer
consistent with (a)?
Rayburn Manufacturing, Inc., is
currently an all-equity firm that
pays no taxes. The market
value of the firm's equity is $2
million. The cost of this
unlevered equity is 18 percent
per annum. Rayburn plans to
issue $400,000 in debt and use
the proceeds to repurchase • WACC will remain unchanged at 18%
stock. The cost of debt is 10
percent per annum. • (MM Proposition)
a. After Rayburn
repurchases the stock, what
will the firm's weighted • rS = r0 + (B/S)(r0 – rB)
average cost of capital be! = 0.18 + ($400,000 / $1,600,000)(0.18 -
b. After the repurchase, 0.10)
what will the cost of equity = 0.20
be! Explain.
c. Use your answer to (b) to
compute Rayburn's • rwacc = {B / (B+S)} rB + {S / (B+S)}rS
weighted average cost of
capital after the repurchase. = ( $400,000 / $2,000,000)(0.10) +
Is this answer consistent ($1,600,000 / $2,000,000)(0.20)
with (a)? = 0.18