Capital Structure Problem. The Risk - Aversion Model of the Value of the firm

Abstract

The Capital Structure Problem (CSP) is one of the big questions in corporate finance. The question is whether the structure of capital of a firm has influence on the market value of that firm – and if it does have such an influence, what is this influence exactly. The goal of the dissertation is to develop a good understanding of the whole issue of capital structure. Such good understanding is the most basic step in developing directions on the best structure of capital. The main features of capital markets and the financing process are analyzed. A mathematical model of the value of the firm, that is influenced by the risk-aversion of investors is developed. Modigilani and Miller have used an illustrative comparison of a pie – a firm – that is divided between different parties. They have assumed that the size of the pie is always the same. However, the value of the firm for shareholders and lenders changes with the level of gearing because there are also other parties, like the state and bankruptcy lawyers, which take pieces of the pie for themselves. MM have pointed out that as the level of gearing increases, the share of the state is decreasing while the expected value of the share that is spent in form of bankruptcy costs is increasing. It is pointed out that the size of the whole pie is changing with the changes of capital structure and that different investors have different “tastes”. Some are less risk-averse, while others are more risk-averse. In presented model the financing process can be compared not to the problem of dividing the pie, but to the problem of baking it. The investors agree what is the taste of the pie going to be (the risk and return of the business of the firm). After that each of them – depending on his “taste” – declares how much of that pie he would like to take. Based on this declaration each of them provides a certain sum of money to buy the ingredients. If the taste of the pie does not suit any of the investors, then none of them would like to finance the pie and – as a result – the size of the pie (the value of the firm) is going to be quite small. If, on the other hand, both investors are satisfied with the taste of the pie, they are going to be willing to provide a lot of financing for the ingredients and the pie is going to be large.