L2: Financial Policy Flashcards
What is the (biggest) source of financing for firms?
Firms finance themselves through retained earnings (internal financing) and selling securities in the market (external financing)
→ most use internal financing (esp. in countries with less developed financial markets)
If external sources of funding are used: Do firms prefer debt or equity?
Fluctuation in external sources of financing
Do capital structures vary across different countries/industries?
Ways to measure leverage
How to find out what the PV of a stake in a firm is today
2 Options
- Use CAPM to estimate discount rate
- Based on the principal of no arbitrage
Arbitrage
Law of one price
Principle of no arbitrage
Valuation by arbitrage: Does the value of the firm depend on the financing type?
Miller Modigliani Irrelevance Proposition
Original MM (1958)
Proof by (absence of) arbitrage
Two firms: U and L
- U: all equity financed (unlevered)
- L: Debt financed (levered)
- Identical except for capital structure
- Both exist for a year
- Produce CF of X at end of the year
Original MM (1958) home-made leverage proof
Does the cost of capital depend on the financing strategy?
Cost of capital
Effect of leverage on returns in the MM world
Why is MM so important?
Pre-MM views
“Debt is cheaper than equity because it has low interest rate”
“Equity is more expensive than debt because equity issues dilute the EPS and drives down stock price”
What are the MM assumptions?
Is the NPV of new security issuance = 0?
- Conditions
- Do we believe these are true?
Are FCF(levered) = FCF(unlevered)?
- Conditions
- Do we believe these are true?
