【正文】 of: ? A fraction b of the investment in the market portfolio ? 1 – b in the riskfree asset which is the tracking portfolio for the investment. Corporate Finance Discount Rate for a Project ? In theory, a project?s discount rate: ? reflects the expected return investors require to hold financial assets (those in the ?replicating portfolio?) ? whose cash flows are thus in the same ?risk class? as the project?s ? Applying this principle: ? Estimate a beta for the project ? Use CAPM to estimate the cost of capital Corporate Finance DR for a project (c) ? Normally there is no ?history? to estimate beta (the project is yet to be undertaken) ? Way out: use the beta of a firm in the same line of business as the project Corporate Finance Betas and leverage ? Beta is a measure of risk, that reflects two types of it: ? Operational (asset) risk ? Financial risk ? We don?t want the second one (which is firmspecific) ? We need an “asset beta” of the beta of the firm?s assets ? We need the formulas mentioned earlier to go from one to the other Corporate Finance Example ? Marriot identified 3 parable firms for its restaurant division: ? Estimate the unlevered cost of capital for the restaurant division, assuming: rf = 4%, MP = 5%, Tc = 34%, parable?s debt is riskfree, and debt is a constant known amount Firm Eq. Beta D E Church39。 Which imply that cash flows are unaffected by capital structure (this is the key of the whole thing) ? Noarbitrage (this is a nonrestrictive assumption) Corporate Finance MM, the other way around ? MM show that under those assumptions, CS is irrelevant ? But this means that if those assumptions are not satisfied, CS is relevant ? The way to look at CS is to look at how it can affect the real cash flows the firm generates: ? Taxes ? Bankruptcy costs ? Agency issues Corporate Finance Corporate tax case ? Taxes ? Consider a firm with a permanent debt level D, paying r% per year ? Yearly interest expenses are rD, which are tax deductible under current tax law ? The firm saves TCrD in taxes every year, where TC is the corporate tax rate ? If we discount this in perpetuity using the interest rate, DTrrDTP V T S CC ??Corporate Finance MM with taxes: ? The difference between the aftertax cash flows of a levered and an unlevered firm is the tax shield of debt: TCrDD ? The difference between VL and VU is then the present value of the future tax shields: VL = VU + PVTS ? If debt is constant (perpetuity) this reduces to: VL = VU + TCD Corporate Finance Costs of Debt : Bankruptcy costs ? So far only benefits of debt ? Firms though don?t have alldebt financial structures ? There must be costs of debt ? The main cost of debt is the probability of financial distress ? FD: situation where a firm can not satisfy its current obligations Corporate Finance Direct Costs of FD ? A firm in financial distress: ? Renegotiate the claims ? Force liquidation (Chapter 7 in US) ? Reanise operations (Ch 11, uitstel van betaling) ? Direct costs are: ? Legal expenses, lawyers etc ? In the US, amount to 13% of firm?s ex ante value Corporate Finance Indirect Costs of FD ? Direct costs don?t seem to be significant enough (1% of market value) ? There must be thus other costs: ? Employee motivation ? Customer loss of confidence ? Credit constraints (and foing of positive NPV investments) ? Debt holderequity holder conflicts Corporate Finance The “static tradeoff theory” ? Combining the tax shield effect with the bankuptcy costs, VL = VU + TCD – BC Leverage $ D* Taxes paid Costs of FD Corporate Finance Other benefits of debt: FCF Hypothesis ? Jensen (1986) (page 766) ? Example: ? Armand Hammer (Occidental Petroleum) spend $120 m in an art museum ? Why shareholders allow this? ? FCF definition (here): funds available for manageme after financing all projects with NPV0 ? These funds should be paid out (otherwise are likely to be invested in negative NPV projects) ? How can management mit to indeed pay out? ? Debt is a solution: it forces management to pay interest and repay principal Corporate Finance Signaling theories ? Suppose firms are divided into two groups, good and bad firms ? If a bad firm increases debt above a certain level, X*, say, then it goes bankrupt ? If managers are paid according to the perceived quality of their firm (the stock price), managers from good firms will want to carry a debt level above X*, to differentiate themselves from bad firms ? Assumption: managers know more about the firm?s quality than shareholders do Corporate Finance Signaling theories: a simple model ? Type A firms will be worth 100 in one year?s time ?