ASSIGNMENT

Assignment

Abstract

We examine how and why shocks to the supply of credit impact corporate financing and investment using the collapse of Drexel Burnham Lambert, Inc., the passage of the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), and regulatory changes in the insurance industry as an exogenous contraction in the supply of below investment-grade credit after 1989. A difference-in-differences empirical strategy reveals that substitution to bank debt and alternative sources of capital (e.g., equity) was extremely limited and, as a result, net investment decreased almost one-for-one with the contraction in net issuing activity. The Modigliani-Miller Theorem states that the value of a firm is invariant with respect to its leverage policy in an arbitrage-free market when there is no corporate income tax and no bankruptcy cost: whether the firm is financed through debt or equity, its value remains the same. We present various forms of this result and contract it with empirical evidence on capital structure of firms.



Assignment

Introduction

Capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's leverage. In reality, capital structure may be highly complex and include tens of sources. Gearing Ratio is the proportion of the capital employed of the firm which come from outside of the business finance, e.g. by taking a short term loan etc.

The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on capital structure, though it is generally viewed as a purely theoretical result since it assumes away many important factors in the capital structure decision. The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. This result provides the base with which to examine real world reasons why capital structure is relevant, that is, a company's value is affected by the capital structure it employs. These other reasons include bankruptcy costs, agency costs, taxes, information asymmetry, to name some. This analysis can then be extended to look at whether there is in fact an optimal capital structure: the one which maximizes the value of the firm.( Myers, 1984, 189)

Capital structure in a perfect market

Assume a perfect capital market (no transaction or bankruptcy costs; perfect information); firms and individuals can borrow at the same interest rate; no taxes; and investment decisions aren't affected by financing decisions. Modigliani and Miller made two findings under these conditions. Their first 'proposition' was that the value of a company is independent of its capital structure. Their second 'proposition' stated that the cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus an added premium for financial ...