CORPORATE FINANCE: ANALYSIS AND THE EMERGING BUSINESS TRENDS

 

Imagine that you were to start your own business. No matter what type you started, you would have to answer the following three questions in some form or another:

Firstly, what long-term investments should your firm take on? The answer for this deals with the line of business you will be in and the type of capital assets you will be requiring to carry on the firm’s operations. In Corporate finance, this is called capital budgeting.

Secondly, where will the firm get the long-term financing to pay for its investments? Also should you bring in other owners and use their money (equity) or should you borrow the money from outside (debt) and in what proportion these two financing techniques should be used to fund operations? Addressing such questions is called capital structuring.

Thirdly, how should the firm manage its everyday financial activities such as collecting receipts from customers and paying suppliers? The term for this in corporate finance is working capital management.

 

These are not the only questions which the firm will need to address but they are definitely among the most important ones.

Corporate finance is the study of ways to answer these three questions.  Thus, it is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions.

Besides at the time of starting up of the company, Corporate finance is also required for other major activities during the life of the company such as for research and development, expansion and diversification, replacement of assets, etc.

Relationship with other areas of Finance

The term corporate finance is often used synonymously with ‘Investment Banking’. Though both the fields involve raising capital for a company, Corporate finance also addresses other concerns as to when to acquire certain assets and pay off liabilities to maximize operational benefits and makes strategic decisions for the financial management of the company. Simply put, corporate finance is also defined as budget management arm of the company.

On the other hand, investment banking is completely different. The goal of investment banking is to raise a massive amount of capital by taking a company public (issuing shares through Initial Public Offer). Instead of borrowing money from one bank, the company can raise huge amount of funds by offering a part of the company's ownership to the general public. Alternatively, a private company can opt for private placement, which is nothing but borrowing money from wealthy individuals and institutional investors rather than from the general public.

Financial risk management, another field of study which is also often associated with corporate finance.  By definition, it is the process of measuring risk for corporates and then developing and implementing strategies to manage that risk. The area is related to corporate finance in two ways. Firstly, the amount of business and market risk a firm is exposed to is directly related to the previous investment and financing decisions made by its’ finance manager. Secondly, the purpose of both these disciplines is to preserve and increase shareholder value.

Emerging Trends in Corporate Finance

One important emerging trend in the context of corporate finance is value-based management.Value-based management involves figuring out ways to create shareholder value through company’s activities. Some of the renowned companies today are using this approach to build shareholders’ confidence in the company.

Another trend we see today is that the salary packages in this area are on a rise.

According to a source, the average annual pay of CFO in Fortune 100 companies exceeds $1 million.

Corporate finance jobs today are considered as one of the hot-job categories. The hot job categories include the international and operationally-oriented positions and the shortages for such jobs is on a continuous rise.

Another significant trend we see is that women are making rapid inroads in corporate finance positions. Finance has become the first field of opportunity for women because promotions are based on merit and not the old-boy network as usually said in the field of marketing. Good examples of women succeeding in corporate finance include Heidi Kunz who engineered General Motor’s turnaround plan in 1992. She then became the CFO of a new ITT spinoff in 1995.

Fifthly, another huge trend  is the growing interest in integrated methods of risk and liability management. Many companies have decentralized their risk management activities where each division or SBU can protect or defend itself from financial losses experienced from fluctuating prices and interest rates (also called hedging). The companies are increasingly permitting this, but aggregation positions into a book at the corporate level and adding controls. Thus, ‘integrated risk management’ is gaining importance.

Financial professionals today are focussing on the need to develop ‘negotiation skills’ because employees who ace such skills are able to settle business negotiations at a good price while building corporate relations at the same time.

Also, apart from this, leadership abilities of a finance manager are also being valued more and more because due to the dynamic nature of financial markets, there lays a huge demand for leaders and innovators who can strategically plan for future financial actions and solve the current risky problems in a given scenario, thus managing and leading the company well with clear defined strategic goals and directions.

The roles in the field are increasing in horizontal as well as vertical depth, focussing on maximization of the return on investment of the assets in a company and managing the overall financial standing of the company rather than just raising money and making financial decisions. This means that the demand for smart, communicative and thoughtful people in finance positions will increase even more in the future.

For smaller firms today, there is a different set of threats and opportunities when it comes to corporate finance. For start-ups, the avenues for funding deals are fewer as compared to big companies. In order to attract the attention and the funds of investors, the emphasis on quality of business proposition and of management is growing.

Venture capital financing is a growing trend. Entrepreneurs usually seek venture capital  when  they need  capital  but are unable to raise it elsewhere. However,  this source of funding was earlier not available for start-up companies  since they  have  not yet  produced  earnings but now the trend is changing a little with effective and promising business plans getting the right amount of finance from venture capitalists.

Thus with these growing trends, corporate finance is definitely on a rise with the growing its growing importance, dimensions, significance and demand for jobs in this field.

This article has been authored by Samiksha Kamra from Great Lakes Institute of Management.

Corporate Finance: Facts and Trends

 

The job outlook in corporate finance is bright.

A recent surveys by Robert Half found a very strong occupational outlook in this field. Shortages in a variety of job categories are taking place. Hot job categories include international and operationally-oriented positions. Hot industries include manufacturing, high-technology, environmental management services and distribution.

Strategic and Global Thinkers Wanted

"Asked to name the qualities that finance executives should have, CEOs top their list with strategic thinking, fresh perspective, and candor. The demand for finance executives who can formulate strategies and foment change on a global scale will only increase in a world where trade barriers are crumbling." CFO Magazine.

Team Players Thrive

It is crucial that a financial officer be a team player, whether at the bottom or the top of a company. At the top, relationships are especially important. For a CEO, the chief financial officer is financial whiz, strategist and partner. The relationship needs to be tight. Consider the role played by Marcus Bennett at Lockheed Martin, the largest defense firm in the United States: "As a key member of [CEO] Augustine's inner circle, [Bennett] is intimately involved in hashing out the company's strategic plans. And when the group decides on a major acquisition or merger, such as the recent linkup with Lockheed, Bennett serves as the primary negotiator. Once a deal is done, he oversees the melding of the balance sheets of the two companies, the combining of employee benefits programs, the squeezing out of cost savings and the overall financial operation of the five current major operating units -- aeronautics, electronics, energy and environment, and space and strategic missiles." ("Stealth CFO", Institutional Investor)

Make a Difference

A good financial officer can create enormous value. For example, when Jerome York switched from being the CFO of IBM to being the CFO of Chrysler, Chrysler's stock gained $1.3 billion the next day, while IBM's stock fell sharply.

Door Wide Open to Women

While still largely a male world, women are making rapid inroads in corporate finance positions around the United States. According to the Detroit News: "Finance has become the first field of opportunity for women because promotions are based on merit - not the old-boy network. Experts say accounting and its natural offspring - finance, treasury, budgeting - are less obstructed by the macho cultures more prevalent in manufacturing and engineering, other traditional paths to the corporate pinnacle." There a wide variety of examples of women who have succeeded in corporate finance. For example, Heidi Kunz engineered General Motor's turnaround plan in 1992 and jumped to become CFO of a new ITT spinoff in 1995. And Judy Lewent is widely credited with creating large amounts of value at Merck as a thinking CFO and strong leader. Mina Brown, CFO at Aviall notes that it is very important for women who want to rise far to get management positions in line divisions.

Value-Based Management is a Huge Trend

Corporate finance professionals are increasingly getting involved in value based management--the practice of figuring out if shareholder value is being created in each of a company's activities. Look for this practice to get hotter and hotter over time. Some of the most innovative companies in the world are now using value management.

Integrated Risk Management Growing in Importance

There is growing interest in integrated methods of risk and liability management. Many companies have decentralized risk management activities where each division or plant can hedge away price and interest rate risk. Companies are increasingly permitting this, but aggregating positions into a book at the corporate level and adding controls.

Quantitative Skills Trade at a Premium

Many corporations are looking for quantitative analysts in their finance group. Merck now employs dozens of rigorous finance professionals who use techniques like Monte Carlo simulation to assess new R&D projects. There will be more and more firms who quantitatively make financial and operating choice. For example, choosing a capital structure by balancing off the expected costs and benefits of debt.

Pay is Rising

Pay throughout corporate finance areas is up. In particular, Chief Financial Officer (CFO) pay is rising. Average annual pay of CFOs in Fortune 100 companies exceeds $1 million. The compensation includes salary, bonus, 'other' income, stock options exercised, and restricted stock. Superstar CFO's can make more than $5 million per annum.

Carry the Torch for Shareholder Value

A company's finance group is the bridge between the investment community and the shop floor. In a day and age, when institutional investors are increasingly active, it's crucial that managers get the message that their job is to create shareholder value. The job of the finance group is to make sure that happens.

A Benefits Focus Can Help

Twenty to forty percent of employee costs now come in the form of benefits. Managing benefits cost-effectively has now become a major challenge for financial officers.

Be Sure to Develop Negotiation Skills

A key skill for financial professionals is negotiating ability. Persons who can put the other side at ease at the negotiating table, while still getting a good price are invaluable. Many firms are actively engaged in acquisitions strategies and require employees who can evaluate possible partners and then negotiate transactions.

Get Ready for Challenge

Being a financial officer can sometimes be more challenging than usual. For example, Barry Weintrob, CFO of the Port Authority of New York and New Jersey had to deal with the aftermath of the World Trade Center bombing on February 26, 1993. From a World Trade Center command center Weintrob and others put together an immediate cost estimate for rebuilding, made sure insurance carriers were notified and kept on paying all bills despite a massive disruption.

Leadership Skills are Highly Valued

Company's want more and more leadership ability in their financial officers. The financial leader of the future will have more and more experience with the dynamics of the financial markets and be innovators in that market as well. She must be a strategic planner, a problem solver and an innovative leader.

Some Companies are Centralizing Corporate Finance Function

Leading-edge companies such as General Eletric are centralizing their finance functions under a system known as shared services. Instead of each business unit having its own CFO and accounting operations, the businesses become customers of a centralized finance function.

Corporate Finance isn't Bean Counting

The oftentimes derogatory view of finance professionals as "bean counters" is changing fast. Technology means the computers count the beans. This frees up time of executives to interpret the results of bean counting. In the words of Roberto Goizueta, the late CEO of Coca-Cola: "The secret isn't counting the beans. It's growing more beans." Ultimately, this means that the demand for smart, communicative and thoughtful people in finance positions will increase even more in the future.

careers-in-finance.com

The Top Corporate Finance Trends of 2013

 

To grow or not to grow? That is the question.

David M. Katz

• What are the trends in 2013 that will define corporate finance?

Any decent editor must frequently try to answer questions like that—or at least carry around in his or her brain a constantly updating ranking of the topics readers most want to know about at any given moment. We make our decisions about what stories to assign and give the most prominence to in that context. 

But spelling them out in black and white for an entire year is another matter. Although we editors have metrics about what most attracts our audiences and keeps them engaged kicking around in our heads, instincts must play a decisive role in deciding what’s most important to you, dear reader. And instincts can be a faulty means of forecasting.

Indeed — pace Alvin Toffler — futurism has always been an inexact science. With such caveats in mind, I offer you the following six trends I and theCFO online/mobile edit team currently believe will be top of mind for finance chiefs in the currently unfolding year. Are we right? Please comment in the space below or e-mail me at davidkatz@cfo.com.

1. The pressure on CFOs to unlock corporate cash hordes will grow. With the fall of Lehman Brothers set to reach its fifth anniversary this fall, worries about liquidity are now same-old, same-old. Consumer spending is starting to rise, and shareholders will begin demanding greater return on their equity via corporate growth. In essence, that means they will press companies to put their capital into areas that can sustain a greater return on their shares, such as investments in plant and equipment, research and development, and hiring (see trend number 2 below).

Yet post-financial-crisis caution continues to affect CFO attitudes toward growth, and early indications are that companies are continuing to squirrel away liquid cash. If that attitude persists through 2013, we’ll see companies continue to try to satisfy shareholders in the most cash-cautious ways: by boosting dividends and buying back their own shares. And don’t expect much in the way of spending on corporate acquisitions, at least through the end of this quarter. After that, the amount of M&A activity depends on the performance of the U.S. economy.

Meanwhile, companies won’t be happy if all that liquid cash continues to gather dust. Treasurers will be reaching for yield, and some have even begun putting money in high-yield bonds in search of returns. It’s risky, but the Fed’s low-interest-rate policy (and the lack of M&A investments) is prodding them to go after junk.

2. To hire or not to hire will be the question. In the wake of the financial crisis, companies have become cracker-jack at doing more with less via automation, consolidation, and simple efficiency. Profits have been up largely on the strength of cost reduction. But the technique of boosting net income by cutting expenses and keeping payrolls at a minimum may well run its course this year. If companies want to grow, they may finally have to start hiring talented help.

3. Like it or not, financial reporting will continue to globalize. After years of hype concerning the coming convergence of U.S. generally accepted accounting principles and international financial reporting standards, the Securities and Exchange Commission has made it clear that the convergence agenda is on a slow boat rather than a fast track.

But regulators find it tough to keep abreast of the markets they tend to regulate — and those markets are relentlessly globalizing. Both corporations and the users of financial statements will, paradoxically, need simpler ways of communicating the result of increasingly complex relationships.

In that light, the movement toward a single, global set of accounting standards may be inexorable. The movement should gain momentum this year if the long-anticipated convergence of two key proposals — on revenue recognition and lease accounting — is finalized as expected in the first half of the year.

4. Tight credit at banks will trigger increased use of alternative sources of funding.With regulations like Basel II hamstringing bank lending, private-capital providers and alternative sources of lending — crowdfunding, especially — will be supplying scads of credit to small and midsize companies. Large companies can issue bonds, so credit will be no problem for them — unless the bond markets reverse direction. In that case, crowdfunding may also come into play among higher-end corporate capital seekers.

5. Big Data will smarten up. With the price of predictive analytics and Big Data tools falling, the finance folks at SMBs seem likely to pull open their firms’ purse strings. But expect a more rational approach to technology spending among CFOs. That strategy will be to take less note of what marketers have to say and compare more closely the cost of Big Data projects in terms of staffing and resources to the money such projects can bring in. The questions, as always, boil down to how much to spend and what to spend it on to get the best bang for the buck.

6. Obamacare will come to ground. We’re still a year away from the Big Bang in health benefits, when employers will face a flurry of possible changes in their benefits plans. On January 1, 2014, for instance, state and federally run health-insurance exchanges will open their doors, enabling many smaller companies to drop health benefits and give employees a stipend to spend via the exchanges. In most cases, though, a penalty of $2,000 per employee per year for not offering “minimal essential” health coverage will be assessed to employers with more than 50 full-time employees.

This year could be a curse or blessing. If finance chiefs continue to act like ostriches about the Affordable Care Act and wait until next year to decide what to do, they will risk having events make the decisions for them. Here’s a healthier approach: use the year to understand the law and the costs and benefits of complying with it.

Better yet, take the time to understand how your entire benefits plan fits in with your overall strategy, approach to employee relations, and risk appetite. Come to think of it, that’s a good way for CFOs to come to terms with any of the trends that may come their way in 2013. 

Firms' debts and cash: Modigliani-Miller vs the real world

 

My considerations about "holding cash" in Should you "be in cash" were entirely focused on what an investor should to about it -- my ideas are very different about what a firm (that the investor part-owns: remember that I consider it crucial to think about investing asowning a part of a firm!) should do about it are very different.
The Modigliani-Miller theorem shows that (under totally idealized conditions) it makes no difference at all what a firm does about its finances -- retain earnings or distribute them in whatever way (dividends, share buy-backs, &c), incur debts or sell more equity, whatever -- the theorem is often known as the capital structure irrelevance principle, exactly because it shows that, under certain assumptions, all of these details about a firm's capital structure and financing are just that, irrelevant.
However, much as the maths in question may fascinate me (and much as I may be personally biased towards this theorem by Modigliani being Italian;-), I consider the beautiful theoretical result in question pretty much irrelevant to the real world -- after all, among those "certain assumptions", it assumes efficient markets (which I consider a myth), no taxes (don't you just wish;-), no asymmetric information (ha!-), no agent-principal issues, and more.
In real life, a company's decision to incur debt (and in what form -- long term vs short, bonds vs bridge loans, intermediate forms now a bit out of favor like preferred stocks and convertible bonds) or hoard cash or both, and of whether, how much, and in what form, return "extra" cash to shareholders, does make a huge difference.
In particular: capital markets can and do "just freeze up", as the recent "great recession" amply proved -- making it risky to hold (especially) short-term debt in excess of the liquid assets available to repay it if needed. Acquisition opportunities do emerge, and being able to make a buy-out offer that's mostly or all cash (as opposed to acquiring-company shares) does make a difference (especially in credit-straitened times) to the chance that the offer will be successful. These considerations push many companies to hold a veritable treasure-hoard of cash and cash-equivalents (to the point where I believe that recently many otherwise-excellent companies, today, have gone overboard in this respect, holding far too much cash in their coffers -- mostly an understandable over-reaction to what the credit markets did over the last three years, I believe).
On the other hand, taxes are, of course, a reality, and have long encouraged companies (weirdly, in my opinion) to hold debt -- interest charges can be deduced from taxable earnings, while dividends, owners' capital gains, &c, cannot -- so, if a company needs a certain amount X of working capital to keep producing its earnings, and people who can supply it with capital require a certain remuneration (yield -- including interests for lenders, and dividends and capital appreciation for shareholders), it's cheaper for a certain fraction of X to be debt (up to the point where potential lenders become nervous about the company being over-leveraged and start demanding higher interest rates) than it is for it to be all equity.
The optimal debt-to-equity ratio, BTW, depends on the specific firm (and, in large measure, on what industry the firm is in): regulated utilities, in particular, have steady, predictable, "boring" income flows (and "boring" is a good thing for a lender), so they may leverage up with very substantial amounts of debt and still pay decent rates of interest -- while their lack of substantial growth prospects makes potential shareholder demand higher dividend yields than they do from firms in other industries (shareholders in utilities aren't looking for prospect of big capital gains).  So, the assessment of whether a certain firm (that you're considering investing in) may be over-leveraged (a big risk to shareholders) or under-leveraged (holding too much cash -- not a risk, but depressing to prospective returns on equity), must depend on analyzing these factors.
And then sometimes there's a bubble in bond markets (we've been going through one of those for a while now!), and solid companies (ones where nobody's worrying about their going bankrupt) can sell bonds at ridiculously low interest rates (like MSFT's recent bonds that pay less than 1% interest!) -- when (for a company with no real risk of bankruptcy, and still some hope of future growth though quite possibly well beyond the "early tumultuous growth" phase of its life cycle) bonds pay much less yield in interest than stocks do in dividends, it's no doubt prudent and responsible for management to "take the near-free cash" by selling such bonds (as long as the resulting increase in the cash hoard is returned to shareholders in some way, or at least used responsibly to fund reasonably-profitable growth, rather than held entirely in sterile cash or squandered in wasteful acquisitions, perks, &c).
Of course, that parenthetical "as long as" condition can be quite a problem (and that's where agent-principal problems can emerge...), but, that's a discussion well worth its own post.  The gist of this one is, rather, that whatever the theory (Modigliani and Miller's theorem) has to say about it, there are proper, prudent and profitable ranges of debt/equity ratio for a firm (depending on its industry sector, credit-market conditions and prospects, and other such considerations) and a prospective investor (or lender) would be well advised to take them into due consideration (carefully avoiding "gut" reactions about firms having "too much" debt, or "too much" cash -- either condition is quite possible, and occasionally even both are observed together!, but each such case must be weighed on its individual merits).
In future posts I plan to discuss acquisitions, and the issue of how (as well as whether andhow much;-) to return "excess cash" to shareholders rather than hoard it (and/or use it to pay down some debt prematurely) -- dividends (regular and special) and stock repurchases.  All of these issues are enmeshed with potential problems that can be couched in principal-agent terms (i.e., potential conflicts of interests and incentives between the firm's owners and its management), and indeed one could say that the agency dilemma is at or near the core of each and every one of them...

 

http://mutnemom.blogspot.com

Trust in Modigliani-Miller theorem is misguided, say former BCBS members

 

Regulators are wrong to believe changing the capital structure of banks will not affect their value as stated by the Modigliani-Miller theorem, say Urs Birchler and Patricia Jackson

Author: Central Banking Newsdesk

Source: Central Banking | 25 Sep 2012

 

 

The drive by regulators around the globe to make banks hold more and better quality equity capital is causing unexpected patterns of behaviour, particularly that of shareholders calling for bank deleveraging rather than supporting new equity placements.

The fundamental problem is not whether or not equity is more expensive than unsecured bonds, but whether or not banks will easily be able to increase either

The reason for this behaviour is due to the Modigliani-Miller theorem not holding true in the real world, according to a paperpublished Urs Birchler, professor of banking at the University of Zurich and a former director at the Swiss National Bank, and Patricia Jackson, head of financial regulation for Europe, the Middle East, India and Africa at Ernst & Young and former head of the Bank of England's financial industry and regulation, in the latest edition of the Central Banking Journal.

The Modigliani-Miller theorem asserts that firms' assets generate cashflows and changing the way those cashflows are paid out to shareholders and debtholders that fund the firm does not change value of the firm. However, the theorem is often cited as the capital structure ‘irrelevance principle' whereby a firm's structure does not affect the value of the firm.

Senior central banker and regulators, such as the Bank of England governor Mervyn King, cite the Modigliani-Miller theorem for their belief that changes in bank capital rules will not adversely hurt banking operations. "The cost of capital overall is much less sensitive to changes in the amount of debt in a bank's balance sheet than many bankers claim," King said in 2010.

However, Birchler and Jackson, both former members of the Basel Committee on Banking Supervision, found that while the Modigliani-Miller theorem holds for banks, "the (stronger) capital structure irrelevance principle is contravened by the ability of banks to raise insured (or implicitly guarantees) deposits, which are risk-insensitive – debt finance thus is subsidised". "The irrelevance principle, as Modigliani and Miller made clear, only holds true under a number of assumptions. These are: efficient markets, the absence of taxes, bankruptcy costs and asymmetric information (including agency costs," the authors said.

Birchler and Jackson added that current research indicates the capital structure irrelevance proposition partially hold, but no research in this area addresses the adjustment period regarding how long will it take after an imposed capital increase to reach a steady state. The research also does not "consider whether there are issues related to the aftermath of the banking crisis, which will make the adjustment more difficult", Birchler and Jackson said.

"The fundamental problem is not whether or not equity is more expensive than unsecured bonds, but whether or not banks will easily be able to increase either," Birchler and Jackson said. "The determination by governments to reprivatise bank risk, therefore, is likely to clash with shareholder reluctance to raise capital levels. Given that equity to risk-weighted assets has to be increased substantially under Basel III, the result could be that shareholders may prefer to see deleveraging through a reduction in lending."

The Modigliani-Miller theorem was developed by Nobel-prize winning economists Franco Modigliani and Merton Miller in the 1950s.

Assumptions of the Modigliani-Miller Theorem

 

by Hunkar Ozyasar, Demand Media

How firms allocate their cash matters.

 

The Modigliani-Miller theorem is a key pillar in modern finance. The theorem has revolutionized corporate finance since it was introduced by the Professors Franco Modigliani and Merton Miller. In 1985, Modigliani was awarded the Nobel Prize in Economics for this as well as other works of his in the field of finance. While it is critical to understand the theorem, Modigliani and Miller make a set of assumptions that render the results of their work only partially applicable to real-life situations.

The Idea

Whether you are running a small deli or a global corporation, you likely will spend a lot of time optimizing the capital structure of the firm. The capital structure refers to where the money to finance the operations will come from. For a small firm, the alternatives may be limited to shareholder equity, bank debt and money owed to suppliers. In the case of a large conglomerate, options may include short- and long-term bonds, preferred stock and loans in various different currencies. The Modigliani-Miller theorem argues that it does not matter how the firm is financed. In the end, the profitability and viability of the firm is unaffected by its financing decisions. However, the theory holds only if a number of underlying assumptions are valid.

No Transaction Costs

The first assumption of the theory is that financial transactions occur at no cost. A firm wishing to sell stock to finance a new factory, for example, can do so without paying commissions to an intermediary, such as an investment bank, or so it is assumed. In real life, there are transaction costs. Not only does a firm have to pay fees and commissions when issuing stocks, bonds, warrants and other instruments, but these transactions also take time. Top management has to put weeks and sometimes months into planning the issuance of these instruments, which takes their focus away from other matters.

Equal Borrowing Costs

For the Modigliani-Miller theorem's conclusion to hold, companies and investors should be able to borrow at the same cost. This assumption is a fundamental pillar of the theorem, because Modigliani and Miller argue that whether it is the firm borrowing money or the investor borrowing money and buying the firm's shares, the end result remains unchanged. In either case, the investor is leveraged, which means she has to assume the risks that go along with borrowed funds. If either the firm or the individual can borrow at different rates -- and they do borrow at different rates in real life -- the theorem doesn't hold up.

Handling of Excess Cash

One of the theorem's underlying assumptions is that when a corporation gets hold of extra money, it will not squander the cash. No matter how much free cash it has sitting in the bank, the firm will invest if there are worthy investment opportunities; but if there aren't, it will return the money to shareholders in the form of dividends. This assumption, too, doesn't always pan out in the real world of corporate finance. Experience shows that firms do tend to squander excess cash, often taking on extremely risky projects with the free cash at hand.

References (2)

About the Author

Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.

Applying the Modigliani – Miller Theorem of Capital Structure to Governments: Why ‘Blue Bonds’ Are Not the Silver Bullet to Kill the Eurozone Debt Crisis

 

Authors: Thomas Grennes & Andris Strazds  ·  June 28th, 2012  · 

In 1958 Merton Miller and Franco Modigliani published an article outlining the idea that in perfect capital markets the value of a company does not depend on its financing structure. The value of assets of a company does not increase if you raise the weight of debt in its financing structure, as the value of equity simply falls by the corresponding amount. In other words, the weighted average cost of capital of a company stays constant independent of the weights of debt and equity in its financing structure because an increase in the debt burden results in the equity becoming more risky and thus equity holders requiring higher returns.

Real life capital markets are far from perfect and imperfections exist in the form of transaction costs, taxes, subsidies and costs of financial distress, to name the most common ones. Thus, the proposition was amended to take into account the effects of imperfections. The conclusion from that – it is possible to increase the value of a company by financial engineering, but only by as much as it can exploit market imperfections such as tax deductibility of interest payments to its advantage. However, the effects of different imperfections can be partly or fully mutually offsetting, for example, the present value of the expected costs of financial distress can outweigh the gains from tax deductibility of interest.

In 2010 Jacques Delpla and Jakob von Weizsäcker came up with the idea of EU countries pooling up to 60% of GDP of their national debt under joint and several liability as senior sovereign debt or the so-called “blue bonds”, while any debt above the 60% of GDP threshold would be issued as national and junior debt or “red debt”. In November 2011 the European Commission published a green paper discussing different aspects of the above scheme along with two other options. Support for the blue bond / red debt scheme has recently been reiterated by Jeffrey Frankel. According to him, relieving countries of responsibility for debt up to 60% of GDP would be substantial assistance to the most troubled countries, although he also admits that it would not by itself put them on a sustainable debt path.

However, if in perfect capital markets the value of a company does not change when changing the relative weights of debt and equity in its financing structure, it is also unreasonable to assume that in perfect capital markets additional value could be created for governments (and ultimately for taxpayers) in the euro area by replacing a part of the national debt with joint blue bonds that would be senior to the other debt. The inevitable result would be that the interest rates on red debt would rise to reflect the much higher risk and the total weighted average cost of borrowing for the respective national government would not change.

Similarly as with changing the capital structure of a company, the blue bond / red debt scheme can only create additional value by exploiting imperfections in the capital markets. Perhaps the most important of them are transaction costs associated with liquidity differences. Depla and von Weizsäcker have also argued that as the joint market in blue bonds would be much more liquid than the present markets for national debt, the greater liquidity would result in lower borrowing costs and have estimated the gain to be about 30 basis points on average. European Commission is more conservative in its assessment and puts the expected yield gain due to better liquidity in the range of 10 to 20 basis points.

However, capital market imperfections would also work in the other direction – by reducing the attractiveness of red debt. If liquidity in the “red” national bond markets goes down further, investors would require even higher rates on the red debt to compensate for the reduced liquidity and increased transaction costs in addition to the much higher expected loss in the event of default. If the European Central Bank deems the red bonds ineligible as collateral for its refinancing operations, which is likely at least for the most heavily indebted countries, their attractiveness would go down even further. Depla and von Weizsäcker mentioned these issues, however, did not make any attempt to quantify them and such quantification would also be difficult. However, a back-of-the-envelope calculation shows that if for a country with the total debt to GDP ratio of 100% the rates on “red debt” went up by further 30 basis points as a result or lower liquidity, it would be enough to nullify the positive liquidity effect of 20 basis points obtained by joint issuance of the blue bonds.

Although the liquidity advantage of the blue bonds is obvious, the countries that would likely benefit from them most are such Eurozone members as Finland, Austria and the Netherlands that have government debt to GDP levels below or slightly above the 60% threshold. The blue bond / red debt scheme would do little if anything to alleviate the debt burden in the most heavily indebted countries. In addition, David Veredas has pointed out the problem of “tail risk” with respect to bond yields in the peripheral euro zone countries in the current situation of high uncertainty.

The solution to the Eurozone debt crisis is likely to emerge from a combination of reducing public current expenditure, increasing public investment expenditure, privatization of state assets in the most heavily indebted countries and using the proceeds to reduce indebtedness, carrying out product and labor market, tax and education reforms, moving towards a banking union, the ECB using its Securities Market Program to provide countries with temporary relief from financial market pressure or even further debt restructuring. However, the blue bond / red debt scheme cannot be the silver bullet to kill the Eurozone crisis beast.

References

Delpla, Jacques and Jakob von Weizsäcker (2010). “The Blue Bond Proposal”. Bruegel Policy Brief, Issue 2010/03, May 2010

European Commision (2011). “Green paper on the feasibility of introducing Stability Bonds”, November 23, 2011

Frankel, Jeffrey (2012). “Could Eurobonds be the answer to the Eurozone crisis?”, VoxEU.org, June 27, 2012

Modigliani, Franco and Merton H. Miller (1958). „The Cost of Capital, Corporation Finance and the Theory of Investment”. American Economic Review 48 (3), pp. 261-297

Veredas, David (2012). “Mutualising Eurozone Sovereign Bonds? First of All, Tame the Tails”. VoxEU.org, June 24, 2012