Corporate Finance - Finanza d'impresa (EN)

FINANCIAL STRUCTURE & SHAREHOLDERS’ RETURN

The optimal financial structure for shareholders is the one that maximizes their profits.

- The indicator to calculate such profits is ROE (return on equity), which indicates the relationship between

- company’s net profits and equity. A financial leverage variation corresponds to a ROE variation (due to the cost

of debt variation, which affects the net profits and to the equity variation).

To evaluate the importance of the financial structure in determining shareholders’ return, it is useful to analyze

- the relationship between ROE and ROI.

The Leverage Effect => find the right value.

→ If the level of debt is too high, we can have problems reversing it if ROI > interest paid to lenders => the higher

→ →

the ratio, the higher the final result and vice versa – but increasing too much the level of debt can create problems

(bc it has to be eventually reimbursed).

If ROI < then it’s not worth using debt.

→ Also, consider other factors that may affect the company’s performance.

→ We need to choose the LEVERAGE RATIO that maximizes the company’s value (connected to shareholders’ profit

→

but not directly value do not have it in our pockets actually.

→

The main remark it is possible to draw from the above formula is that, if a positive spread between ROI and i

- exists, recurring to the financial leverage implies that the shareholders’ return increases. In fact, by increasing the

leverage ratio, the ROE increases proportionally. This relation is called the “leverage effect”.

Obviously, it is always necessary to consider the financial risk related to a debt increase.

Otherwise, in case of ROI < i, the best strategy would be not to use financial debt and maximize the use of equity.

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FINANCIAL STRUCTURE & ENTERPRISE VALUE

The analysis of the financial structure in a medium-long term perspective should not consider only financial

- ratios (such as ROE), but also other factors.

All these factors can be summarized within a single concept: the optimal financial leverage ratio (or at least the

- most suitable) is the one that maximizes the whole company’s value. The value maximization implies the

minimization of the cost of capital (which includes, as we will see, both cost of debt and cost of equity).

Therefore, the optimal financial structure is the one that better responds to the industry, the strategy and the

- goals of the company. OPTIMAL D/E RATIO

TRADITIONAL THEORY

The traditional theory states that there is an optimal financial structure that maximizes the enterprise value of a

- company by the use of debt and the leverage it offers. This enables the company to minimize the cost of capital.

Debt is cheaper than equity, so a moderate increase in debt will help to reduce the cost of capital.

- However, any increase in debt also increases the risk for shareholders. Therefore, according to the traditional

- theory, a certain level of debt rises up to a very high risk of bankruptcy. That risk increases also the cost of debt.

In any case, the cost of debt < cost of capital but cannot be infinitely high.

→ →

An increase in debt also increases risk for shareholders.



Graph: decrease because of risk of bankruptcy and higher cost of debt decreases value of the company.

→ There’s no optimal structure.



MODIGLIANI & MILLERS’ THEORY

According to the traditional theory, the optimal capital structure of a company is where benefits and costs of

- debt are best balanced.

In 1958, Modigliani and Miller formulated a theory that totally contradicts the traditional wisdom, assuming

- that in perfect markets, barring any distortions, there is no optimal capital structure.

Efficient Markets

Hypothesis:

perfectly transparent markets and no asymmetric information,

- no agency costs,

- companies and investors borrow at the same interest rate,

- no bankruptcy costs,

- no taxes for companies and investors,

- homogeneous investor expectations of companies’ future incomes,

- perfectly rational investors.

-

1 st Proposition: The Value of company is not affected by

its D/E ratio.

Company’s cost of capital does not depend on its financial

structure.

The theorem states that, in the absence of taxation

- and in perfect financial markets, the value of a

levered company is exactly the same as an unlevered company.

HP: Efficient markets but with taxes on companies’ profits.

-

2nd Proposition: The Value of company is affected by its D/E ratio.

Thanks to tax benefits resulting from the deductibility of passive interests, a company increases its value by

increasing its D/E ratio. In case of inclusion of corporate tax, debt financing becomes an attractive option.

TRADE-OFF THEORY

According to the trade off theory, the higher the debt, the greater the risk that a company will not be able to

- meet its commitments and get bankrupt.

When a company is in financial distress, its tax advantage disappears, since it no longer generates sufficient

- profits.

Moreover, the high debt level may lead to restructuring costs and lost investment opportunities if financing is no

- longer available.

According to the trade-off theory, the optimal debt ratio appears to be when the present value of the tax

- savings arising on additional borrowing is offset by an increase in the present value of financial distress and

bankruptcy costs.

Hypothesis: Efficient markets but with taxes on companies’ profits and bankruptcy costs.

- When in distress – 2 condition of Modigliani

nd



theory disappears.

The intersection is the optimal value.

 We can have advantages in increasing debt - but if



too high, the problems and risk > benefits.

Optimal financial structure: benefits = debts.



PECKING ORDER THEORY Cost of capital increases by going down => finance as soon as



possible, otherwise you would have to use debt and then financial equity to

do it (it costs more for the company).

KEY FACTORS INFLUENCING FINANCIAL DECISIONS

There are many factors that contribute to the investor’s or manager’s decision of investing in a project.

- The effective return from the investment may differ from the expected return, mainly due to risk and time, that

- is the moment in which the effective return will be generated.

RETURN

The return on investment is the sum (amount) of the cash flows that the project (investment) can generate in

- the future can be managed by this.

→

Cash flows can refer to different management areas, depending on the investment.

- Low levels of uncertainty (low risk) are usually associated with low potential returns, whereas high levels of

- uncertainty (high risk) are associated with high potential returns.

Ability to calculate the uncertain future cash flows.



RISK

In the valuation process of a company’s investment opportunities, it is necessary to forecast the future trend of

- some factors. The forecasts may be correct or not and the effective result can differ from the expectations.

The risk of the project consists in the possibility that effective return can deviate from expected return.

- Risk means uncertainty today over the return on a project tomorrow.

- The future is unpredictable and therefore there are difficulties in calculation of expected return.

Unique and market risk (cannot be eliminated).



TIME

Also TIME has a value due to the fact that money’s value changes with time.

- Every transfer of assets has a cost/return depending if you are investing or raising money.

- The financial value of time is a cost in case of discounting: the money you get in the future could be invested

- today; the cost is equal to the loss you face not investing the money.

On the contrary, it is a return in case of capitalization.

The discount rate considers time and risk.

-

RISK AND RETURN Return = free risk premium + expected risk

→

premium.

THE RISK/RETURN RELATIONSHIP

HOW TO ESTIMATE FREE RISK RETURN (rf ) AND EXPECTED RISK PREMIUM? 

rf = the free risk rate is conventionally the return on treasury bills: it is considered unaffected by what happens

- to the market.

It is more difficult to calculate the Expected Risk Premium, that is the premium that should persuade the investor

- to choose one option instead of another. All the factors related to the specific investment must be considered.

Obviously, the aim of every person who is taking the decision is to have high returns and, at the same time, to

- lower the level of risk as much as possible.

Assuming that rational investors are risk adverse, the theory developed by Markowitz (CAPM) attempts to

- minimize risk for a given level of expected return.

The theory is a formulation of the concept of diversification in investing, with the aim of selecting a collection of

individual stocks that has collectively lower risk than any individual stock.

Try to have same return but with lower level of risk => try to do that by diversifying investment: investing in

→

different things, not only one => different kinds of risk and also different levels of it => less risky.

THE THEORY OF DIVERSIFICATION

UNIQUE RISK AND MARKET RISK

Diversification allows to reduce portfolios’ risk because values of different stocks do not move exactly together.

- It is impossible to totally eliminate risk, because it is impossible to have stock values perfectly uncorrelated; there

- are common components to all stocks.

Diversification reduces risk rapidly at first, than more slowly, until the point in which the effect on standard

- deviation (one way to measure risk) is equal to zero (or really close to zero) (until SD = 0).

systematic risk cannot be eliminated since related to entire economy.

→ What diversification does

THE RISK/RETURN RELATIONSHIP

Capital Asset Pricing Model (CAPM)

The is a theory that allows to determine the relationship between risk

- and return.

Considering both market risk and unique risk, the CAPM states that in a competitive market, the expected risk

- premium on each investment is proportional to its SENSITIVITY to market fluctuations Beta (β).

→

The higher is sensitivity, the higher should be premium.

 Expected risk premium on each investment is proportional to its sensitivity to market fluctuations.



CAPITAL ASSET PRICING MODEL (CAPM)

Where:

rf is the interest rate free risk, conventionally the return on Treasury Bills.

- rm is the Market Risk Premium, that is higher than the return on Treasury Bills while it includes the risk taken by

- investors that have choosen a market portfolio.

rm – rf = Market risk premium

- Cannot completely eliminate risk but can instead minimize risk on that specific investment by diversifying it

 => Return = risk free rate + expected return.

Higher sensitivity = higher expected risk premiu