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CLASS NOTES ON CORPORATE FINANCE - TAU - corporate finance class notes
Preliminary and highly incomplete
CLASS NOTES ON CORPORATE FINANCE
by
Yossi Spiegel*
Berglas School of Economics, Tel Aviv University
Spring 1999
Copyright ? 1999 by Yossi Spiegel
* Parts of these class notes are based on class notes written by Elazar Berkovitch and Ronen Israel.
Of course, all errors in the current notes are mine alone.
Corresponding address: School of Economics, Tel Aviv University, Ramat aviv, Tel Aviv, 69978, Israel.
Fax: (972)-3-640-9908, E-mail: spiegel@ccsg.tau.ac.il
TOPIC 1: THE M&M PROPOSITIONS
1. The M&M (AER, 1958) propositions
Consider a firm that operates for infinitely many periods. For now, we will not worry about what does
the firm do exactly (i.e., which industry it operates in, how does it compete in the market, who manages
the firm, what kind of investment and strategic decisions the managers make, etc.) and instead we will
treat the firm as a black box that somehow generate each year some amount of money. Specifically, we
will assume that each period, the firm generate a random cash flow, X~ , distributed over the interval
[X0, X1] according to some distribution function. For now, the exact properties of this distribution
function are not important for us; the only thing we need to know is that the expected cash flow of the
firm in each period is X^ . We shall now make some assumptions about the environment in which the firm
operates:
A1 There are no transactions costs for buying and selling securities and there are no bid-ask
spreads (i.e., the prices for buying and selling securities are the same).
A2 The capital market is perfectly competitive (firms and investors are all price takers).
A3 There are no bankruptcy costs.
A4 There are no corporate or personal taxes.
A5 All agents (firms and investors) have the same information.
Next, consider two firms, U and L, that are exactly the same (in particularly, they have the same
distribution of cash flows in each period), except for their capital structures. Firm U is all-equity.
Suppose that investors can earn a rate of return on investments which bear the same risk as the risk
associated with the cash flow X~ . Since the capital market is perfectly competitive, and since the entire
cash flow of U accrues to its shareholders, the market value of U, which is the total value of its shares,
2
is equal to the sum of the discounted value of U's infinite stream of cash flows, with the discount factor
being equal to :
(1)
That is, the market value of U must leave investors indifferent between investing in U's equity and
investing in alternative securities that bear exactly the same risk. In the Appendix I show that VU can be
written as follows:
(2)
Firm L is leveraged. To simplify matters, suppose that L's debt is in the form of consol bonds
with face value D, that pay the amount rD in every period, where r is the per-period interest rate on
riskless bonds.1 The assumption that L has consol bonds simplifies the exposition because we do not
need to worry about maturity dates and new issues of debt. By Assumption A3, bankruptcy is costless.
To simplify matter further, let's assume in addition that the firm's debt is riskless in the sense that rD
X0. That is, the firm can meet its debt obligation even in the worst state of nature. As we shall see later
on, given that bankruptcy is costless, the results would be just the same even if debt was risky, i.e., even
if rD > X0, but then the computations become messier. Given that debt is safe, the market value of L's
consol bonds (i.e., the price that investors will be willing to pay for these bonds) must be equal to the
present value of all future interest payments, given by
1 Consol bonds (short for consolidated bonds) are bonds that do not have a redemption value and pay
an annual interest payments indefinitely (at least in principle). These bonds were first created in England
in 1750 by Henry Pelham who was then the British prime minister. Until 1914, consol bonds formed the
bulk of the British national debt. Moreover consol bonds enjoyed a reputation for being a safe and highly
liquid asset and they formed the largest single security traded on the stock market in England. Today,
consol bonds refer to a 2.5% bond issue by the British Government from 1888 (i.e., they pay each year
2.5% on their face value) and they form only a small fraction of the British national debt.
What are the components in the evaluation of corporate finance?There are three components in the evaluation of Corporate Finance: quizzes, the projects, and the final exam. Projects • The projects are worth 18% of the course mark. • Completion and submission of the projects is mandatory.
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