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Economics 434 Theory of Financial Markets

Economics 434 Theory of Financial Markets. Professor Edwin T Burton Economics Department The University of Virginia. On to “accounting”. Balance Sheet. Liabilities. Assets. New Worth. Plus. Revenues A B C Expenses D E F Net Income Taxes Net Income after Taxes. Income Statement.

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Economics 434 Theory of Financial Markets

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  1. Economics 434Theory of Financial Markets Professor Edwin T Burton Economics Department The University of Virginia

  2. On to “accounting” Balance Sheet Liabilities Assets New Worth

  3. Plus • Revenues • A • B • C • Expenses • D • E • F • Net Income • Taxes • Net Income after Taxes Income Statement

  4. Bal Sheets & Inc Statements are linked Bal Sheet Bal Sheet Date 1 Income Statement Date 2 (Period from Date 1 to Date 2)

  5. Back to the Balance Sheet Balance Sheet Liabilities Assets New Worth

  6. The “No-Arbitrage” Principle • Does not require “equilibrium • Means • Cannot make something out of nothing • Cannot make an infinite amount out of a finite investment

  7. Balance Sheet Liabilities Assets Net Worth Modigliani Miller Theorems on Leverage

  8. Value of the Firm According to Modigliani-Miller • Net Worth • Plus Liabilities In other words, ASSETS !!!

  9. MM-1 In a world of no taxes “Value of the Firm” Is independent Of the leverage ratio Irrelevance of Leverage Theorem

  10. Broader Implications from MM-I • US inadequately levered in the 1960’s • US still relatively less levered that rest of world

  11. MM-II “Cost of equity capital” is a linear function of the debt/equity ratio “Cost of debt capital” is whatever the going interest rate is

  12. Other Famous Modigliani-Miller Theorem • Assume no-arbitrage • Assume no taxes • Should firms pay dividends (or do something else with the cash) • Modigliani-Miller Divd Theorem is • It doesn’t matter • Irrelevance of dividends • But if taxes, then dividends are irrational!!!!!

  13. The End

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