The main contents of this chapter include all of the following: Issues firms face in decided how much to borrow, Modigliani Miller irrelevance theorem, historical changes in leverage, behavioral finance response to extreme version of Modigliani Miller. | Lecture 11: Corporate Equity, Debt and Taxes Leverage Corporate Leverage is measured by Debt D divided by equity E. Highly levered firms court bankruptcy Unlevered firms cannot go bankrupt (Microsoft owned $ billion of other firms’ long-term debt and $ billion in cash and short-term investments in 2000. Xerox Corporation Consolidated Balance Sheet 1999 (in millions) Assets: Cash $126 Receivables $15940 Inventories $2961 Buildings & equipment $2456 Other $7331 Total $28814 Xerox Corporation Consolidated Balance Sheet 1999 Cont. Liabilities Short-term debt $3957 Long-term debt $10994 Deferred taxes $2263 Preferred stock $669 Other $6020 Shareholders equity $4911 Total $28814 Microsoft Balance Sheet 2000 (in $ millions) Assets: Cash & equivalents $4846 Short-term investments $18952 Property & equipment $1611 Equity and debt investments $17726 Other $9015 Total assets $52150 Microsoft Balance Sheet 2000 in $Millions Continued. Liabilities Income taxes $585 Accounts payable $1016 Unearned revenue $4816 Other $4065 Stockholders equity $41368 Total $52150 No debt: no corporate bonds or bank loans! Comparing Market Caps Xerox Market Capitalization = 667 million shares $ = $ billion 2/11/01 (compare with shareholders equity = $.) Microsoft Market Capitalization = billion shares $ = $. (compare with stockholders equity=$) Expected Return on Assets Expected return on assets = rA= weighted cost of capital = expected return on a portfolio consisting of all of a companies liabilities. Value of Firm in Terms of rA Suppose Dividends are constant =Div and debt is perpetual, paying Coupon C. D=C/rD and E=Div/rE Value of firm = V=D+E=C/rD+Div/rE Value of firm = V = (C+Div)/rA rA=weighted average cost of capital = (D/(D+E))rD+(E/(D+E))rE Firm’s Objective: Maximize Overall Market Value V Present Value Model: V=(C+Div)/rA Strategies: Increase C+Div, or lower rate of discount rA. Traditional Position (Before Modigliani-Miller) Both rD and rE are not much affected by the ratio, probability of bankruptcy is so low that it is approximately zero. Since rD
