1. Economics 434 Financial Markets Professor Burton University of Virginia Fall 2015 November 17, 2015

2. Third Part of the Course Begins Now First Two Parts – Modern Portfolio Theory: state pricing, CAPM – Fixed Income: Default Free, ABS, Mortgages, Etc. This Part: Leverage and Corporate Finance – Mostly about “valuation” – Assumes companies have income and cash flow – Valuing without income/cash flow is “how high can you dream” – Warren Buffett (he didn’t say that, but that’s what he believes) November 17, 2015

3. Questions about value What determines value? How is valued traded from one person to another? How should I “invest” to increase value in an optimal way? Value comparisons – Balance Sheet, Income Statement, Stock November 17, 2015

4. Balance Sheets define “Book Value” for a business at a specific point in time November 17, 2015 AssetsLiabilities + Net Worth Balance Sheet for XYZ Corporation, November 17 th, 2015

5. “Book Value” is Net Worth (can be negative) LHS of Balance Sheet is “operational” RHS of Balance Sheet is “financial” If there are no liabilities, value of Assets is Book Value Value of a business is not Net Worth Value of a business is Liabilities + Net Worth November 17, 2015 AssetsLiabilities + Net Worth Balance Sheet for XYZ Corporation, November 17 th, 2015

6. Value of What? The equity? (this is what common stock is valuing) – But the value of a company is equity plus debt – Equity plus debt is known as “enterprise value” Value of a company is always “enterprise value” not equity value Thus enterprise value is the value of the assets (equity plus liabilities) on the balance sheet November 17, 2015

7. In determining “enterprise value” does the amount of leverage matter? Assume no taxes Assume prices are such that no arbitrage is possible Answer: Leverage is irrelevant – This is known as Modigliani-Miller Theorem 1 on Leverage (MM-1) But, What if there are taxes – personal, business, whatever? – Then leverage matters, due to “tax shield” effects November 17, 2015

8. Why is MM-1 True? (Why is leverage irrelevant, absent taxes)? Basically because value of the assets are not changed by leverage If there are taxes, then value of assets can be changed by leverage (by reducing pre-tax income using tax shield) November 17, 2015

9. Meanwhile, Back to the Balance Sheet November 17, 2015 AssetsLiabilities + Net Worth Balance Sheet for XYZ Corporation, November 17 th, 2015 What happens if we make $ 1 million today? What will tomorrow’s balance sheet look like?

10. Meanwhile, Back to the Balance Sheet November 17, 2015 AssetsLiabilities + Net Worth Balance Sheet for XYZ Corporation, November 18 th, 2015 +$ 1 million If it were a loss of $ 1 million, just change plus sign to minus sign

11. Balance Sheets Change Due to the income or loss between balance sheets Plus any financings: debt or equity offerings that effect the RHS For the purposes of this example, assume that there are no debt or equity offerings between balance sheet dates November 17, 2015

12. So, How Do We Come Up with Income or Losses during periods between balance sheet dates? Revenue – Expenses But revenue, expenses are not all cash items Some are simply accounting entries, no cash changing hands November 17, 2015

13. Examples of “non-cash” Items Receivables and Payables – Accounts receivable (money you are owed but it hasn’t arrived yet – Accounts payable (money you owe, but have not paid yet Changes in value of assets and liabilities November 17, 2015