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					Chapter 11:
Learning Objectives
   The Leverage Concept
   The Production-Investment decision:
       no leverage, leverage, with spread
   The Irrelevance Proposition
       Does how you borrow matter?
   Tobin’s q: An Investment Rule
The Spread
             24

             20

             16           Prime business rate
   Percent




             12

             8
                       Five-year fixed-term rate
             4

             0
                  80    82   84    86    88   90     92   94   96   98   00   02   04
                                                   Year
Leverage

   Investing with borrowed funds
   Is possible because of the existence of a
    postive spread between borrowing and
    lending rates
                   R L > R DEP

   Can be measured either by the Debt/Equity
    ratio or the Capital/Asset ratio: Table 11.1
    illustrates
Leverage and Interest Rate Volatility

Assets              Pre       Liabilities
Bonds                 $52.00 Deposits       $50.00
Total                  $52.00 Equity         $2.00
Leverage
ratio=50/2=25

Assets              Post
Bonds                  $50.49 Deposits      $50.00
(52/1.03=50.49)

Total                  $50.49 Equity         $0.49
Leverage
ratio=50/0.49=102
THE BIS REQUIREMENTS: An Example-
OPENING

Balance sheet assets           $
Cash                                             1000
Government bonds                                10000
Loans to Corporations                            5000
Mortgage Loans                                   8000
Total                                           24000
OBS
Standby letter of credit                         2000
Commercial letter of credit                      4000
Total                                            6000
Equity= 5000; Capital ratio = 5000/24000=0.21
THE BIS REQUIREMENTS: An Example- Risk
adjusted
Balance Sheet Actual           Conv. Factor   Risk-adjusted
Cash                    1000         0                    0
Gov bonds              10000         0                    0
Loans to Corp           5000         1                 5000
Mortgage                8000         .5                4000
loans
Total                  24000                          9000
OBS
Standby letter          2000         1                 2000
Comm letter             4000         .2                 800
Total                   6000                          2800
Risk-adjusted capital ratio= 5000/9000=0.56
Examples of Actual Leverage Ratios
The Production-Investment Decision

   The Production-possibilities frontier concept
     incorporates the notion of diminishing
    marginal returns
   provides an explanation of the trade-off
    between current vs. future production
   think of a firm “producing” a financial service
The Production-Investment Decision

   The firm “produces” some output subject to a
    given technology Figure 11.1
   Owners of the firm “consume” the firm’s
    output (e.g., profits, dividends)
   Assume that the production-investment
    decisions are separate
   Assume that the spread is zero (at first)
   Leverage can then improve welfare Figure
    11.2
Production Possibilities Frontier

    Q2




                                    Q1
Production Possibilities Frontier

    Q2




                   O


                               I*


                                    Q1
Leverage


     Q2




           Q1
Leverage


     Q2




           Q’




                Q1
Leverage


      Q2




           O

               I*
                    Q1
Leverage


       Q2


                     I**

            Q’

                           O’

                 O

                                I*
                                     Q1
Leverage


           Q2
                  Q’


                           I**

           Q2 ‘


                                 O’            With leverage
       Q2 **

                       O
                                          I*
No leverage        Q1 ‘           Q1 **
                                                       Q1
The Irrelevance Proposition

   Does the source of borrowed funds matter?
   The Modigliani-Miller [M-M] theorem says NO,
    based on the following assumptions:
     tax treatment for debt vs. equity the same

     investors know the value of the firm

     ignore transactions costs

     ignore “agency” costs
Two Scenarios

   Buy k% of firm “A”        Borrow k% of D2 to
       OR                     buy k% of EQ1
   Buy k% of firm “B”        Net Cost is = k%
                             (EQ2 - D2)
   The two should be         But this should be
    equivalent,                the same as k%
    otherwise NO ONE
                               EQ2, otherwise NO
    would buy either “A”
    or “B”                     ONE would buy
                               either “A” or “B”
Limitations of the M-M theory

   Dividend payments could be different from
    interest payments
   Tax treatment of dividends & interest may be
    different
   Management answers to different groups
   Transactions costs of debt vs. equity not the
    same
   Asymmetric information problem rears its
    head again
Tobin’s q

   How does the market value a firm?
   Stock prices are a portent of the future performance of a
    firm and can signal mergers &acquisitions
   If stock prices rise then future profits will be higher, and
    vice-versa q >1  future profitability 




                q = [Market Value /Replacement Value]
                           {of firm’s capital}
Summary

   Firms borrow to invest via leverage
   Leverage is measured by the debt-equity or
    capital-asset ratios
   Leverage can be shown to improve welfare
   Borrowing via debt or equity is irrelevant
    under certain assumptions
   Tobin’s q provides a useful measure of a
    firm’s potential value

				
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posted:9/20/2012
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