Corporate finance is a broad, complex subject. Here, we will just touch on a couple of significant concepts.
Corporations own long-lived assets, like the fruit tree that we used as an example in basic financial calculations. These long-lived assets typically require a large up-front expenditure, and they then yield income over time. Corporations cannot pay for these assets out of current income, so they must raise funds in the capital markets. The two main classes of funds are equity (common stock) and debt (corporate bonds, commercial paper, and bank loans).Using a high ratio of debt to equity is called leverage. It is called leverage because the debt acts like a lever in that it allows a given amount of equity to carry more than its weight in assets.
A firm that raises $100 million in equity capital and $100 million in debt can purchase $200 million in capital assets. A firm that raises $100 million in debt and $900 million in debt can purchase $1 billion in capital assets.
The highly-levered company, or highly-leveraged (sic) company, will have a return on equity that is very sensitive to changes in the value of its capital assets. If you own a baseball team that is financed mostly with debt, then a good attendance will mean a high return, but bad attendance will mean a low return or loss.
The Modigliani-Miller Theorem
Fifty years ago, Wall Street practitioners thought that companies with higher leverage would have higher stock prices. However, in 1958, Franco Modigliani and Merton Miller made an argument that leverage should not matter.
The Modigliani-Miller argument is that it is individuals, not corporations, that have the final say on leverage. The local phone company, Verizon, has physical assets, including a network of wires and switches. If I would like to take a position in those assets that is more levered than Verizon's debt-equity ratio, I could borrow money to buy stock in Verizon. My borrowing is personal leverage. Conversely, someone who wants to take a position in phone company assets that is less levered than Verizon's debt-equity ratio, that person could have a portfolio that combines some Verizon stock with some interest-bearing securities.
The Modigliani-Miller theorem states that the total value of a firm depends on the underlying value of its assets, not on how they are financed. Investors are said to "pierce the corporate veil" and to evaluate the physical (and intellectual) assets of the company, regardless of its financial structure.
Merton Miller tells a funny story about being asked to explain the Modigliani-Miller theorem, which helped win a Nobel Prize, in a 10-second sound bite.
The way I heard the story, Miller was asked by a reporter to explain what made the theory worthy of a Nobel Prize. Miller responded, "Say you have a pizza, and it is divided into four slices. If you cut it into eight slices, you still have the same amount of pizza. We proved that! Rigorously!"
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