Analytical Methods for Lawyers Finance Unit Last updated 01 Mar 07

Schedule Class Topic 3/1 Introduction Spreadsheet primer 3/6 TVM – future value Exercise 1 3/8 TVM – present value Exercise 2 3/20 Discount rate Exercise 3 3/22 ECMH Readings 3/27 Risk and return Exercise 4 3/29 Valuation – medical malpractice Group problem 1 4/3 Valuation – corporate appraisal Group problem 2

Why the firm?

Theory of the Firm Labor Capital Firm Supplies Equipment Land Adam Smith “Wealth of Nations” Land

Why not contracting?

Theory of the Firm Capital Labor Entrepreneur Supplies Equipment Land Ronald Coase “Nature of the Firm” Land

Theory of the Firm Capital Labor Entrepreneur Supplies Equipment Land Ronald Coase “Nature of the Firm” Land

What is the modern public corporation?

Separation of ownership/control Entrepreneurs (capitalist managers) Labor Capital Supplies Equipment Adolf Berle & Gardiner Means Land

Separation of ownership/control Professional managers Capital (diffuse public ownership) Labor Supplies Equipment Adolf Berle & Gardiner Means Land

What is ideal ownership – debt or equity?

Optimal debt-equity mix Managers Equity Labor Debt Franco Modigliani & Merton Miller “Cost of Capital” Supplies Equipment Land

Optimal debt/equity mix Priority Fixed rate of return Net Assets Debt Optimal debt/equity? Equity Equity: Voting control Residual returns

Optimal debt/equity mix Less debt: Large equity cushion Lower risk  lower cost Net Assets Debt Equity Optimal debt/equity? More equity: Low leverage Lower returns  higher cost

Optimal debt/equity mix More debt: Small equity cushion Higher risk  higher cost Net Assets Debt Optimal debt/equity? Equity Less equity: High leverage High returns  lower cost

Average cost of capital Modigliani & Miller Return on Assets Cost of debt Cost of equity Average cost of capital High D/E (90/10) 15% 14% 24% Mid D/E (50/50) 10% 20% Low D/E (10/90) 6% 16%

Average cost of capital Modigliani & Miller Return on Assets Cost of debt Cost of equity Average cost of capital High D/E (90/10) 15% 14% 24% Mid D/E (50/50) 10% 20% Low D/E (10/90) 6% 16%

Average cost of capital Modigliani & Miller Return on Assets Cost of debt Cost of equity Average cost of capital High D/E (90/10) 15% 14% 24% Mid D/E (50/50) 10% 20% Low D/E (10/90) 6% 16%

Average cost of capital Modigliani & Miller Return on Assets Cost of debt Cost of equity Average cost of capital High D/E (90/10) 15% 14% 24% 15%* Mid D/E (50/50) 10% 20% Low D/E (10/90) 6% 16% * Interest is deductible (debt subsidized by govt)

How unify ownership and management?

“Managerial Behavior” Leveraged firm Managers Outside debt Inside equity Labor Michael Jensen & William Meckling “Managerial Behavior” Supplies Equipment Land

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