Advanced Corporate Finance

Advanced Corporate Finance

Assignment 1

26th January 2015

1. The Fisher Separation result states that in the presence of perfect (frictionless) capital markets, investment and financing decisions are independent. The goal of the firm is to increase its value to the fullest extent, regardless of the preferences of the firm's owners.  

Borrowing and lending will be carried out at the same rate and all investors will agree on financial decisions.

This is important because decisions regarding how to finance a project are irrelevant when we value the project. All we are interested in is maximising firm value.

1. When markets are frictionless, the financing decision becomes irrelevant and it does not matter whether a company is financed by equity or debt. Firm value is made up of equity and debt, and thus it will accrue to either shareholders or debtholders. Changing the capital structure only affects how the value is distributed, but not the value of the firm itself.

Debt is less risky than equity, so it has a lower cost of capital. Leverage increases the risk of equity, however, thus raising the equity cost of capital. So by adding more debt, the change in the capital structure weights is exactly offset by the change in the cost of equity, so the WACC stays the same regardless of the capital structure.

The assertions above are MM Proposition I and MM Proposition II respectively.

Under the assumption that the WACC is constant, increasing the firm’s debt/equity ratio correspondingly increases the risk (beta) per unit of equity. This is best explained in the following equations:  

[pic 1]

[pic 2]

We can see that the return on equity is a linear function of increasing the debt ratio.

However, this is under the assumption that there is no possibility of default. When a possibility of default exists, the return on equity will become concave as all value will accrue to debtholders first before it is distributed to equity holders, making equity in the firm very risky, which then needs to be compensated with an increasing level of returns.

1. The first step is to estimate the cost of equity of the firm. Models such as CAPM are unsuitable due to the lack of historical prices of the firm. Much of the methodology described below is based on material made publicly available by Aswath Damodaran from NYU.

The first step is to estimate the beta of the firm using comparable companies. This would entail collecting a group of publicly-traded comparable firms, preferably in the same line of business, but more generally, affected by the same economic forces that affect the firm being valued. We then need to find their average equity betas and their average debt/equity ratios to calculate the unlevered beta for the firm. After that, we estimate the debt/equity ratio for the private firm by either assuming that the firm will move to the industry average debt ratio or that the beta for the firm will converge on the industry average beta. We now estimate the optimal debt ratio for the firm, based on its operating income and cost of capital. Given that we now have the levered beta and optimal debt ratio, we can estimate the cost of equity using the CAPM formula.