EXP 482 Corporate Financial Policy

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

2. Course Description An Historical Perspective • Before 1950 • Heavily institutional, largely normative • Ad 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 process

3. Fundamental Building Blocks of Modern Finance • Efficient Markets Theory • Portfolio Theory • Asset Pricing Theory • Option Pricing Theory • Agency Theory • The structure of contracts • Individual incentives ü ý þ EXP 481 ü ý þ EXP 444

4. Fundamental Building Blocks of Modern Finance • Capital Budgeting • Corp. Investment Policy • Capital Structure • Compensation Policy • Leasing Policy • Hedging Policy • Dividend Policy ü ý þ EXP 480 ü ý þ EXP 482

5. Readings Chew–The New Corporate Finance: Where Theory Meets Practice Brealey & Myers–Principles of Corporate Finance Brickley/Smith/Zimmerman – Managerial Economics and Organizational Architecture

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

7. Selected Financial Variables

8. The Modigliani/Miller Theorem • 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.

9. A Quick Lesson on Logic If A then B Implies If not B then not A

10. Modigliani/Miller II • If the choice of capital structure affects current firm value, then it does so by: • Changing tax liabilities • Changing contracting costs • Changing investment incentives

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

14. N “ obody goes there any- more. It’s too crowded.” I was talking to Stan Musial and Joe Garagiola in 1959 about Ruggeri’s restaurant in my old neighborhood in St. Louis. It was true! Yogi Berra

15. W “ e’re lost, but we’re making good time!” I said this on the way to the Hall of Fame in Cooperstown 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 was giving me a hard time, so I gave it back. Yogi Berra Casey Stengel & Yogi Berra, 1972

16. A “ lways go to other people’s funerals, otherwise they won’t go to yours.” Mickey and I had been talking about all the funerals we’d been to in that year. We were saying that pretty soon there would be no one left to come to ours. Yogi Berra

17. When asked if I wanted my pizza cut into four or eight slices, I replied: “Four. I don’t think I can eat eight.” Yogi Berra

18. An Option Pricing Application V = E + D D E

19. Valuing Debt and Equity of a Levered Firm f(V*) Consider a Simple Firm: • Fixed investment policy • One bond issue • No coupons • Single maturity date • Face value = F V* F D* V* F E* V* F

20. Valuing Debt and Equity of a Levered Firm f(V*) Consider a Simple Firm: • Fixed investment policy • One bond issue • No coupons • Single maturity date • Face value = F V* F D* V* F E* V* F

21. Valuing Debt and Equity of a Levered Firm f(V*) Consider a Simple Firm: • Fixed investment policy • One bond issue • No coupons • Single maturity date • Face value = F V* F D* V* F E* V* F

22. Valuing Debt and Equity of a Levered Firm • 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.

23. Black/Scholes Model Comparative Statics C = C (S, X, T, s², r, DIV)

24. The Value of a Call Option At Expiration C* S* X

25. -rT e X The Value of a Call Option Prior to Expiration C S X

26. An Option Pricing Application 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 V* F E* V* F

27. An Option Pricing Application V = E + D V = E(V, F, T, σ², r, DIV) + D(V, F, T, σ², r, DIV) D E

28. A Slightly More Complicated Example What 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/∂σ²) dσ² dE =(∂E/∂V) dV + (∂E/∂σ²) dσ²

29. Junior and Senior Debt E* V = E (V, Fs, Fj, T, σ², r, DIV ) + Dj (V, Fs, Fj, T, σ², r, DIV ) + Ds (V, Fs, Fj, T, σ², r, DIV) V* F(s) F(s)+F(j) D(j) V* F(s)+F(j) F(s) D(s) V* F(s) F(s)+F(j)

30. Why Senior Bondholders Care About the Issuance of Junior Debt • The legal system and absolute priority • Priority in time

31. Consider a Bond that Pays Coupons Time V = E (V, F, C1, C2 ... CT, T1, T2 ... TT, σ², r, DIV) + D (V, F, C1, C2 ... CT,T1, T2 ... TT, σ², r, DIV)

32. Convertible Bonds 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.

33. Convertible Bonds E* (1-a)V* V = E(V, F, a, T, σ², r, DIV) + CB(V, F, a, T, σ², r, DIV) V*-F V* F F/a CB* aV* F V* V* F F/a

34. Many Bonds Have Other Imbedded Options Consider 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)?

35. Many Bonds Have Other Imbedded Options For a bond with a silver delivery option D= D[ . . .σs², ρ(v,s)] Silver Prices Low High Firm Value High Low

36. Investment Policy Involves Imbedded Options • R&D • Flexibility

38. This article is in hard copy handout