EXP 482Corporate Financial PolicyClifford W. Smith, Jr.Winter 2007*covers Miller (1988) and Smith (1979) on reading list.

An Historical Perspective Before 1950 Heavily institutional, largely normativeAd 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 processCourse Description

Fundamental Building Blocksof Modern FinanceEfficient Markets TheoryPortfolio TheoryAsset Pricing TheoryOption Pricing TheoryAgency TheoryThe structure of contractsIndividual incentivesEXP 481EXP 444

Fundamental Building Blocksof Modern Finance Capital Budgeting Corp. Investment Policy

Capital Structure Compensation Policy Leasing Policy Hedging Policy Dividend PolicyEXP 480EXP 482

Chew The New Corporate Finance: Where Theory Meets Practice

Brealey & Myers Principles of Corporate Finance

Brickley/Smith/Zimmerman Managerial Economics and Organizational ArchitectureReadings

Grading Several homework assignments (25%) Midterm exam on January 26 (20%) Class participation (5%) A final exam on March 16 (50%)

Selected Financial Variables

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 LogicIf 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 incentivesModigliani/Miller II

Proof of the Modigliani/Miller Theorem** Attributed to Yogi Berra

obody goes there any-more. Its too crowded.NI was talking to Stan Musial and Joe Garagiola in 1959 about Ruggeris restaurant in my old neighborhood in St. Louis. It was true!Yogi Berra

ere lost, but were making good time!WI said this on the way to the Hall of Fame inCooperstown 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 wasgiving me a hard time, so I gave it back.

Yogi BerraCasey Stengel & Yogi Berra, 1972

lways go to other peoples funerals,otherwise theywont go to yours.AMickey and I had been talking about all the funerals wed been to in that year. We were saying that pretty soon there would be no one left to come to ours.Yogi Berra

Four. I dont 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 ApplicationDE

Valuing Debt and Equity of a Levered FirmConsider a Simple Firm:Fixed investment policyOne bond issueNo couponsSingle maturity dateFace value = FFFFV*V*V*f(V*)D*E*

Valuing Debt and Equity of a Levered FirmConsider a Simple Firm:Fixed investment policyOne bond issueNo couponsSingle maturity dateFace value = FFFFV*V*V*f(V*)D*E*

Valuing Debt and Equity of a Levered FirmConsider a Simple Firm:Fixed investment policyOne bond issueNo couponsSingle maturity dateFace value = FFFFV*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, s, r, DIV)Black/Scholes Model

The Value of a Call Option At ExpirationC*S*X

The Value of a Call Option Prior to ExpirationCSX

An Option Pricing ApplicationFV*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 ApplicationDEV = E + D

V = E(V, F, T, , r, DIV)

+ D(V, F, T, , r, DIV)

A Slightly More Complicated ExampleWhat 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/) d dE = (E/V) dV + (E/) d

Junior and Senior DebtF(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, , r, DIV )

+ Dj (V, Fs, Fj, T, , r, DIV )

+ Ds (V, Fs, Fj, T, , r, DIV)

Why Senior Bondholders CareAbout the Issuance of Junior DebtThe legal system and absolute priorityPriority in time

Consider a Bond that Pays CouponsTimeV = E (V, F, C1, C2 ... CT, T1, T2 ... TT, , r, DIV) + D (V, F, C1, C2 ... CT,T1, T2 ... TT, , 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 a of the common stock.Convertible Bonds

Convertible BondsFFV*V*E*CB*V*FaV*V*-F

V = E(V, F, a, T, , r, DIV)

+ CB(V, F, a, T, , r, DIV)F/aF/a(1-a)V*

Many Bonds Have Other Imbedded OptionsConsider 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 OptionsFor a bond with a silver delivery option D = D[ . . . s, (v,s)] Silver Prices Low High Firm ValueHigh Low

Investment Policy Involves Imbedded OptionsR&DFlexibility

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