Fundamentals of Financial Economics Lecture 4

Fundamentals of Financial Economicsلا،

Entrepreneurial Firm – Production and Investment Decisions

• Simplifying assumptions:
  • Entrepreneur has knowledge of a production technology
  • Initial supply of resources is available for the entrepreneur
  • Initial supply of resources can either be sold for cash or used in a productive process
  • The world of certainty
  • Perfect capital market
  • Two-period model
• Entrepreneur's opportunities:
  • Productive opportunity can be represented by a transformation curve, T (K1, K2) = 0
  • Transformation curve reflects efficient use of funds
  • Slope of the transformation curve indicates the firm's Marginal Rate of Return (MRR)
• Maximization of initial wealth:
  • Commodity storage example: maximizing initial wealth with storage facility value
  • Dominated investment policy: liquidating (0K1*) and investing (K1*K1) to obtain the initial wealth of w1
  • Tangency condition: MRR = r
• Simultaneous choice:
  • Production-investment and consumption decisions
  • Fisher Separation Theorem: step 1: choose the optimum production, step 2: choose the optimum consumption pattern

Entrepreneur with No Initial Resources

• Entrepreneur has marketable product and understands productive technology but has no resources to finance the business
• Total wealth = X2/(1+r)
• Increment to wealth is independent of whether (0I1*) is borrowed and (0K1) invested or whether (0K1) is sold and the entire amount of (I1*K1) is borrowed

Investment Decisions Made by Managers on Behalf of Owners

• Two additional assumptions:
  • Corporation has many owners, and there is no reason to assume that the owners' preferences are all the same
  • Owners of a corporation do not make the operating decisions of the firm but rather hire professional managers and delegate decision-making power to these managers
• Implication:
  • Managers should maximize the market value of the firm they operate
  • If the market value of a firm is maximized, so is the market value of any owner's proportional share of the firm's earnings

Consequences for Investment and Financing Decisions

• Market-value-maximizing firm will invest up to the point where the Marginal Rate of Return equals the Market Rate of Interest
• Determination of the total investment in a firm depends on two things: technology and cash flow, and market rate of interest
• It does not matter whether the firm is owned by many stockholders or a single owner
• Whether the firm uses its own money (retained earnings) or external financing makes no difference

Separation of Operating and Financing Decisions

• Operating decision is the decision to invest X1K1, which determines the amount of the firm's output it will produce and sell
• Financing decisions are separate from the operating decision
• Existing owners can arrange any profile of cash withdrawals from the firm at Times 1 and 2 as long as the profile has a present value equal to MV1

Separation of Managers' and Owners' Decisions

• The separation principle says the firm's managers determine the optimal investment X1K1 and hence its market value MV1
• If the firm has a single owner, he/she decides what consumption standards, with a present value of MV1, are preferred
• If the firm has many owners, a given owner is entitled to only some proportion of market value, say αMV1 (0 ≤ α ≤ 1)

Fundamentals of Financial Economics

Debt vs. Equity

• A firm decides to borrow $100 million for 1 year at a 10% interest rate, considering three possible outcomes for the firm's operating earnings and their consequences for lenders and owners.
• The example illustrates the concept of financial leverage, which is the use of financing that has fixed, but limited, payments.

Capital Structure and Financial Leverage

• A firm with $20 million of assets, all financed with equity, identifies investment opportunities requiring $10 million of new funds, which can be raised in three ways:
• Financing package 1: Issue $10 million equity
• Financing package 2: Issue $5 million of equity and borrow $5 million with an annual interest of 10%
• Financing package 3: Borrow $10 million with an annual interest of 10%
• The effect of financial leverage on earnings per share (EPS) depends on the return on assets (ROA) compared to the cost of debt:
  • If ROA = cost of debt, EPS is not affected by the choice of financing
  • If ROA > cost of debt, financing package 3 (with the greatest financial leverage) has the highest EPS
  • If ROA < cost of debt, financing package 3 (with the greatest financial leverage) has the lowest EPS
• The degree of financial leverage (DFL) can be calculated as:
  • DFL = (Earnings before interest and taxes) / (Earnings before interest and taxes - Interest)

Capital Structure and Taxes

• The deductibility of interest is a government subsidy of debt financing, allowing interest to be deducted from taxable income.
• The interest tax shield is the benefit from tax deductibility of interest expenses, which shields operating earnings from taxation.
  • Tax Shield = Marginal Tax Rate × Interest Expense
• The value of the tax shield depends on whether the company can use an interest expense deduction, and if a company has deductions that exceed operating earnings, it can "carry" this loss to previous tax years.

The Cost of Capital

• The cost of capital is the return that must be provided for the use of investors' funds, and it's a marginal concept.
• Estimating the cost of capital requires:
  1. Determining the proportion of each source of capital to be used.
  2. Calculating the cost of each financing source.
  3. Estimating the weight of the cost of each source of funding (by the proportion of that source in the target capital structure).

The Irrelevance Theory: Modigliani-Miller Theorem

• The Modigliani-Miller theorem states that changes in capital structure do not affect the market value of the firm, assuming:
  • Investor expectations are homogeneous.
  • Financing decisions have no effect on the business risk of the firm.
  • There is no tax advantage associated with debt financing relative to equity financing.
  • There are no costs associated with voluntary liquidation or bankruptcy.
  • No transactions charges are paid on asset's purchase or sale.
  • Any financial arrangements available to firms are available to individuals on the same terms.
  • Financial transactions capable of adversely affecting the positions of creditors relative to owners are not permitted.
• The cost of capital to the firm remains constant as the debt-equity ratio changes in a perfect capital market with no corporate taxation.

Conclusions

• An optimal capital structure is the mix of financing that maximizes the firm's value.
• Financial leverage makes use of additional debt, increasing the firm's debt-equity ratio.
• Taxes provide an incentive to increase debt financing because interest paid on debt is a deductible expense for tax purposes.
• The weighted average cost of capital is the estimate of a firm's cost of capital found by computing the after-tax cost of each type of funding source and weighting each cost by the targeted percentage of the funding source sought by management.