Effect of Borrowing on Equity Value

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

Effect of Borrowing on Equity Value

Postby "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>

Return to “2002”

Who is online

Users browsing this forum: No registered users and 1 guest