1、1,CHAPTER ONE: MM Theory and No Arbitrage,MM Theory,Two measurements of value Accounting: book value historic cost,Finance: market value net present value,2,Assets = Liabilities + Equity,Accounting Equality: duel entity system Book value measurement,Fund use,Fund source,Finance Equality: Fund use =
2、Fund source Market value measurement,3,Corporate FinanceAssets Liabilities and EquityAsset 1 Asset 2 LiabilitiesAsset 3. Equity.Asset nTotal Assets Total Liabilities and Equity,Accounting: Yes! Finance: No!,Capital Market,Real Economy,NPV,Firm Value,+ NPV,4,Liabilities ValueEquity Value,Liabilities
3、ValueAssets Value,Capital Structure,Financial leverage:,or,Has a change of financial leverage any impact on the firm value?,5,M&M Theory,M&M assumptions: Frictionless assumptions No income taxes No transaction costs No information asymmetry No cost to resolve interest conflicts among stakeholders Al
4、l liabilities are risk-free,6,Notes:,A mini case: does capital structure matter?,Two companies EBIT Capital structure Firm value,$10 million p.a,bonds: $40 million, 8% shares: 600,000,As share price: $100 per share,expected return: 10%,1 million shares $100 million,B,?,A,Bs bond: risk-freethe share
5、number is supposed share expected return:,?,7,(Risk-free),No,Position Immediate Cash Flow Cash Flow in the Future,Replication of As Stock Using Bs Stock and Bonds,Bs Total Payments = Bs Net Earnings + Interest Payments,= ( EBIT - $3.2 million) + $3.2 million = EBIT,Suppose price of Bs stock = $90 pe
6、r share,Short sell 1% As shares at $100 per share,Buy 1% Bs sharesat $90 per share,Buy 1% Bs bonds,+$1,000,000, 1% of EBIT, $540,000,1%( EBIT $3,200,000 ), $400,000,1% $3,200,000,Net Cash Flow,$60,000,0,Arbitrage,Price of Bs stock = $100 per share,8,M&M Proposition 1,Proposition 1:Under M&M Assumpti
7、on, i.e., in the frictionless environment, the total market value of a firm is independent of its capitalstructure.,Think of the firm as a gigantic pizza, divided into quarters. If now, you cut each quarter in half into eights, the M &M proposition says that you will have more pieces, but not morepi
8、zza., Merton Miller,9,The cost of capital depends on its use and not on its source.,Proposition!,10,Comparison of Stocks between A and B,State of the Economy,EBIT,Company A Company BEPS Net EPS (1 million shares) Earnings (600,000 shares),Bad business $5 million $5 $1.8 million $3.00 Normal business
9、 10 10 6.8 11.33 Good business 15 15 11.8 19.67 Mean 10 10 6.8 11.33 Standard deviation 4 6.81 Beta 1.0 1.0 1.67 NOTE: Each state of the economy is equally likely.,11,Weighted Average Cost of Capital,Cost of capital of the firm without liability,Risk premium of WACC,Financial leverage,M&M Propositio
10、n 2: The cost of equity of a firm equals the cost of capital of the firm without liability and the risk premium of WACC multiplied by financial leverage.,12,All transactions in financial markets are zero NPV transaction activities.,Proposition!,13,Implication of M&M Theory,Frictionless environment d
11、oes not exist in the real world. Taxes Transaction costs Information asymmetry Costs resolving conflict of interest Liabilities are risk-bearing,14, Tax Shield,Company A:,Tax rate: T = 33%,Company A Company B,Claimant,Creditors Shareholders Government Tax Authority,Total Firm Value before Taxation,$
12、100 million $100 million,0,67 million,33 million,Company B: (1T)(EBITInterests)+Interests = (1-T)EBIT+TInterests,40.0 million,40.2 million 19.8 million,$13.2 million,15, WACC with Taxes,Other M&M assumptions hold,Has a change of financial leverage any impact on the firm value ?,Answer: Yes !,Discoun
13、t rate for cash flow of the firm,16, Stock Price,Share Number Total Equity Share Price,Company A:,1 million,67.0 million,$ 67,Company B:,600,000,40.2 million,$ 67,?,If Company A were to announce an issue of $40 million debt to be used to repurchase and retire common stock,As capital structure = Bs c
14、apital structure,Market reaction: price of As share would go up to reflect the $13.2 million tax shield: $(67.0 + 13.2) million / 1 million = $80.2 per share.,Where is the benefit of the tax shield?,17,State Prices,Risk-free security,Risk-free interest rate,Bond A,Bond B,18, Basic Securities,Basic S
15、ecurity 1 Basic Security 2,= ?,= ?,Portfolio Basic Security 1, Basic Security 2,replicating,Bond A,=,19,Replicating risk free security,Portfolio Basic Security 1, Basic Security 2,replicating,=,Let,State Prices,P=EmX,20,Replicating Bond A and Bond B,No Arbitrage,Questions ?,Do there exist such kind
16、basic securities in the real world? Are there enough basic securities that can be used to replicate all the payoff of securities in the market?,Answers :,Find some equivalent instruments instead of basic securities. It involves in market completeness.,21,Replication via equivalent instruments,Portfo
17、lio Bond A, market value risk-free security,22,Market Completeness,Whenever the number of different instruments used to replicate securities equals the number of states so that we can attain any payoff of securities in future , in such a circumstance, the market is a complete one. Otherwise, the mar
18、ket is incomplete.,Completeness is a core concept of finance theories !,23,P=E(mx),In complete market, there is a unique m that is consistent with market observable security prices In incomplete market, there are many ms that are consistent with the market observable security prices.,24,Summary of C
19、hapter One,No Arbitrage Equilibrium Replication Methodology State Prices Technology: P=EmX,25,CHAPTER TWO: Time Value of Money and Term Structure of Interest, Discounted Cash Flow Formula,Yes ! is the expected rate of return, i.e., the mean of the discount rates for different terms,Let,No ! is the d
20、iscount rate that cannot be used for so long period,?,26, Determination of Interest,Capital production ability the more the capitals expected return, the higher the interest rates and vice versa.Uncertainty of capital production ability the more the uncertainty, the higher the risk premium required
21、and the higher the interest rates and vice versa.Time preference of consumption the stronger preference to current consumption, the higher the risk premium required and the higher the interest rates and vice versa. Risk aversion the more the risk aversion, the higher the risk premium required and th
22、e lower the risk-free interest rates.,Four basic factors,27,The Benchmark of Interest, Yield to Maturity (YTM),YTM varies with different financial instruments, because the exposure of financial instruments are quite different and the required risk premiums differ from each other.,Risk-free interest varies with terms . Its called the term structure of interests., Risk-free interests,?,?,No!,Yes!,
