Exercise 2 Q1. Discuss the priority structure and returns to debt and equity. Explain how the risk preferences might differ between debt and equity holders.

Secured debt: debt financed with collateral as part of their lending contract Ordinary debt: debt financed without collateral Subordinated debt: paid after secured and ordinary debts are been paid off Preferred stock: its holders are entitled to a fixed, predetermined repayment, but the firm is not obliged to pay back this specified amount and non-repayment does not trigger default. It doesn’t normally have voting right. Common stock: a firm cannot pay dividend on common stock unless the cumulative payments due to preferred stockholders have been made

Summary Debt holders get their claim to a firm’s income first Equity holders have the claim to the “residual” profit If debt is not repaid, shareholders receive nothing and debt holders are entitle to the existing income

Risk Preferences-Debts Given the concave nature of the debt holders, they would prefer less risky investment with stable cash flow.

Risk Preferences-Equity Risk-neutral or well-diversified investors benefit from increase in risky if the claim they hold is convex (resembles equity) and they lose if their claim’s return is concave (resembles debt). Diversified equity holders prefer increases in risk while debt holders dislike increase in risk.

Q2.Discuss the characteristics of projects financed by venture capitalist. Why debt finance would not be suitable for these projects? Characteristics Intense screening of proposals (similar to sophisticated debtors) Strong control right and few covenants (dis-similar to sophisticated debtors. V.C is active in terms of controlling the company whilst sophisticated debtors are more passive unless covenants were breached)

Venture capitalist Specialize in highly risky projects Concentrated equity position Seats on the board of directors Bring expertise and industry contracts

Strong control rights Detailed outline of the stages of financing and target, limited funding at each stage Right for unilaterally stop funding at any stage, put option to withdraw investment Right to demote or fire managers based on performance Rights to control future financing, especially preemptive rights Ownership of preferred stock and seniority in liquidation

Why these projects are not suitable for debt finance With low collateral (good idea cannot be used as collateral for debtor to secure debt finance) Limited cash flows at the start (short-term debt obligations could lead to bankruptcy) New industry, high growth potential (cash flow not stable)

Q3. Discuss the two propositions of the basic Modigliani-Miller model. Let VE and VD denote the values of equity and debt for debt repayment D. Then the total value: VE + VD = E(max(0,R − D))+E(min(R,D))= E(R) E(·) denotes the expectation with respect to the distribution of the random variable R.

Modigliani and Miller’s conclusion The financial structure is irrelevant. Managers and investors might as well devote their time to more useful tasks and simplify their financial structure by issuing a single claim, which could be labeled “100% equity” or “equity without debt” (this is the claim depicted by the 45◦ line in previous). The firm would then become an “all-equity firm.”

Let 𝑃 𝑡 denote the price of a share at the end of period t (after the dividend payment) and 𝛽 the discount factor. Choice of dividend 𝑑 𝑡 and number of shares 𝑛 𝑡 ( 𝑛 𝑡 < 𝑛 𝑡−1 in the case of share repurchases, 𝑛 𝑡 > 𝑛 𝑡−1 when new shares are issued). Arbitrage: 𝑃 𝑡 =𝛽𝐸( 𝑑 𝑡 + 𝑃 𝑡+1 ) (1) Accounting equality between the sum of revenue and amount raised in the capital market 𝑅 𝑡 + 𝑃 𝑡 𝑛 𝑡 − 𝑛 𝑡−1 = 𝑛 𝑡−1 𝑑 𝑡 + 𝐼 𝑡 (2)

The total value of shares in the firm at the end of period t is therefore: 𝑉 𝑡 = 𝑛 𝑡 𝑃 𝑡 =𝛽 𝑛 𝑡 𝐸 𝑑 𝑡+1 + 𝑃 𝑡+1 =𝛽𝐸 𝑅 𝑡+1 − 𝐼 𝑡+1 + 𝑛 𝑡+1 − 𝑛 𝑡 𝑃 𝑡+1 + 𝑛 𝑡 𝑃 𝑡+1 =𝛽𝐸 𝑅 𝑡+1 − 𝐼 𝑡+1 + 𝑉 𝑡+1 =𝐸( 𝜏>1 𝛽 𝜏 ( 𝑅 𝑡+1 − 𝐼 𝑡+1 )

Development of the Theory Tax considerations - Trade-off theory of capital structure Asymmetric information - Pecking order theory Conflict between executives and debtholder -Free cash theory

Trade-off theory of capital structure