AFM373 Lecture Notes - Lecture 12: Capital Structure, Pepsico, Morgan Stanley
3 Jul 2018
School
Department
Course
Professor
Morgan Stanley part 2
Investment decision
Free cashflow problem
Managers destroying money by taking negative NPV projects for the sake of growth.
Value firms have these problems because they are stable, and they ran out of positive
opportunities.
Growth firms don't have this problem because they have lots of good projects sitting
around, they won't be finding negative NPV projects.
For value firms, equity is a cushion and so you need more debt. Just leverage up. Debt acts as a
discipline and it helps us solve the free cashflow problem because there won't be free cash
lying around for managers to destroy and there's now obligations for the firm to do well in
order to pay down the debt.
What is the underinvestment problem?
Underinvestment problem is what?
The opposite of free cashflow problem. That you are so leveraged with debt, you will be
missing out on good projects out there.
What sort of firms most need to avoid it?
The growth firms because they need financing to fund all the attractive projects.
If you got too much debt, 99% debt,
My asset in a year will be 50/50 103 or 97
So average of 100.
Next year if when I have to repay the debt
In the good times when asset is worth 103, debt holders will get 99 and equity holders get 4
(the rest).
In the bad times when asset is worth 97, debt holders will get 97 and equity holders get 0.
This debt is risky because we may default on it (may not get paid all)
Average for the equity is 2, and average for the debt is 98. this is the market value
We wouldn’t want to invest in the new growth opportunity because positive NPV.
We need to fund it $1, it's not going to come from debt holders obvious, so assume we get it
from equity holders.
In good times, when asset is worth 104.5, debt holders will get 99 and equity holders get 5.5
In bad times, when the asset is worth 98.5, debt holders will get 98.5 and equity holders get 0
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Document Summary
Managers destroying money by taking negative npv projects for the sake of growth. Value firms have these problems because they are stable, and they ran out of positive opportunities. Growth firms don"t have this problem because they have lots of good projects sitting around, they won"t be finding negative npv projects. For value firms, equity is a cushion and so you need more debt. That you are so leveraged with debt, you will be missing out on good projects out there. The growth firms because they need financing to fund all the attractive projects. If you got too much debt, 99% debt, My asset in a year will be 50/50 103 or 97. Next year if when i have to repay the debt. In the good times when asset is worth 103, debt holders will get 99 and equity holders get 4 (the rest).
