Effect of Borrowing on Equity Value

Locked

"Peter Hollings"
Junior Member
Posts: 14
Joined: Fri Mar 29, 2002 3:39 am

Effect of Borrowing on Equity Value

Post by "Peter Hollings" » Sat Dec 07, 2002 12:55 pm

Nicolo,

The economic theory behind this is fairly well developed. It begins
with some work done by Franco Modigliani and Merton Miller who
demonstrated that, under certain assumptions, the total value of a firm
(i.e., the value of debt plus equity) was invariant with financial
leverage. The critical assumption that they made that does not exist in
the real world is that bankruptcy is costless. In fact bankruptcy is
costly: not only are there legal costs, but customers leave and the firm
loses some or all of its value as a going concern. The whole is worth
more than the sum of its parts. There are currently several striking
examples such as Enron and WorldCom that might be sources of real-world
data. Viewed this way, the value of a firm is the sum of the values of
debt and equity, less the expected value of the bankruptcy costs. Since
bankruptcy occurs when the firm cannot meet its debt obligations, the
probability of bankruptcy generally increases as the proportion of debt
in the firms capital structure increases. Since the bankruptcy costs
are a stochastic variable, capturing their variability would be a
critical element of the model. Perhaps this could be done effectively
with SD, although it calls to mind a Monte Carlo approach.

There are some further refinements that might be considered. Two come
to mind: First, the firms debt might be indexed in whole or part. In
this case, it is important to capture the correlation between the index
and the firms operating earnings. For example, an industry such as
airlines generally experiences a cyclical earnings pattern in phase with
the economy. If the chosen index is also positively correlated with the
economy, the firm might undertake additional debt (relative to a fixed
interest rate scenario) without increasing the risk of bankruptcy. A
second refinement concerns the effect of the debt and resulting interest
payments on the "beta" of the firms stock. That is, for reasons of
diversification, investors prefer to own some stocks that are less
correlated with the market. Thus, to the degree that debt affects the
correlation of the firms equity earnings with the market, this would
also be a factor.


Peter Hollings
Atlanta, GA USA
From: "Peter Hollings" <
phollings@attbi.com>

Locked