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

Leverage Investing with borrowed funds Is possible because of the existence of a postive spread between borrowing and lending rates Can be measured either by the Debt/Equity ratio or the Capital/Asset ratio: Table 11.1 illustrates R L > R DEP

Leverage and Interest Rate Volatility AssetsPreLiabilities Bonds$52.00Deposits$50.00 Total Leverage ratio=50/2=25 $52.00Equity$2.00 AssetsPost Bonds (52/1.03=50.49) $50.49Deposits$50.00 Total Leverage ratio=50/0.49=102 $50.49Equity$0.49

THE BIS REQUIREMENTS: An Example- OPENING Balance sheet assets $ Cash1000 Government bonds10000 Loans to Corporations5000 Mortgage Loans8000 Total24000 OBS Standby letter of credit2000 Commercial letter of credit4000 Total6000 Equity= 5000; Capital ratio = 5000/24000=0.21

THE BIS REQUIREMENTS: An Example- Risk adjusted Balance Sheet ActualConv. FactorRisk-adjusted Cash Gov bonds Loans to Corp50001 Mortgage loans Total OBS Standby letter20001 Comm letter Total 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 Q1Q1 Q2Q2

Q1Q1 Q2Q2 I* O

Leverage Q1Q1 Q2Q2

Q1Q1 Q2Q2 Q’

Leverage Q1Q1 Q2Q2 O I*

Leverage Q1Q1 Q2Q2 Q’ O O’ I* I**

Leverage Q1Q1 Q2Q2 Q’ O O’ I* I** Q 1 ** Q 2 ** No leverage Q 1 ‘ Q 2 ‘ With leverage

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” OR Buy k% of firm “B”  The two should be equivalent, otherwise NO ONE would buy either “A” or “B” Borrow k% of D 2 to buy k% of EQ 1 Net Cost is = k% (EQ 2 - D 2 ) But this should be the same as k% EQ 2, otherwise NO 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