Valuing Companies Flashcards
Assumptions for answering valuation questions
Assume investors have already optimised portfolio with which they are happy - if corporates make share more risky the shareholders adjust theri outside portfolio to return the risk to what it was before.
What is leverage
Borrowing money. If predicted on the idea that shareholder required return does not change whent he company borrws money then, leverage seems like a good thing from shareholder view as it increases value. Unrealistic
Modigliani and miller
Irrelavance proposition: Shareholders should be indifferent to the capital structure: mixture of equity or debt a company chooses. Leverage neither creates nor destroys value.
Whats the idea of the tax shelter
Reflects that dividends are paid out of post tax income while corporate interest payments come out of pre tax income: oversimplistic as incentive for firms to borrow as much as possible to return profits to shareholders without them suffering tax.
Is debt tax deductible
Yes
How can company be valued like an option
If A>D then debt can be repaid
if A<D company is insolvent and wound up.
If company assets get more risky the options become more valuable: good for the shareholder but bad for the bondholder whose option downside risk increases.
Who holds a call and put option in valuing a firm
The shareholder has call option on assets of firm : not liable for debts as they have limited liability: worst that can happn is investment is worthless.
Bond holders hold a put option on the assets: Risk free debt - option to defalt
Why are pensions more complex than a standard merton debt model
Trustees have recourse to assets fo employer: two lines of defense
Not all members are equally exposed to pension default risk, those retired on date scheme defaults get prioirty,
Profit sharing on the upside.
What are some frictional costs
Fees from banks, advisors with raising further capital
Liquidations costs
Loss of future business when customers fear they may not have their pensions/investment
Asymmetric tax rules
Because of these frictional costs shareholders have incentives for companies to match assets and liabilities to minimise these.
