
















Study with the several resources on Docsity
Earn points by helping other students or get them with a premium plan
Prepare for your exams
Study with the several resources on Docsity
Earn points to download
Earn points by helping other students or get them with a premium plan
Community
Ask the community for help and clear up your study doubts
Discover the best universities in your country according to Docsity users
Free resources
Download our free guides on studying techniques, anxiety management strategies, and thesis advice from Docsity tutors
Lecture Notes for the financial part of the course.
Typology: Lecture notes
1 / 24
This page cannot be seen from the preview
Don't miss anything!
Shengxing Zhang LSE
October 10, 2016
I (^) a financial contract is a promise of some payment in the future
I (^) payment contingent on the state of the economy, c(s)
I (^) example from lecture 1
I (^) Alice
I (^) receives today £100, I (^) save £100 in a bank I (^) receives next year £
I (^) Bob
I (^) needs £100 to buy seeds and borrows from the bank I (^) with probability 0.5, earns £119 if the weather is good I (^) with probability 0.5, earns £101 if the weather is bad I (^) repays £101 to the bank
I (^) a deposit contract for £100 pays £101 in both states
I (^) A firm’s debt-equity ratio does not affect its market value.
I (^) market value of a firm is pE ⇥ E + pD ⇥ D
“Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as it is. Or
he can separate out the cream, and sell it at a considerably higher price than the whole milk would
bring. ... The Modigliani-Miller proposition says that if there were no costs of separation, (and, of course,
no government dairy support program), the cream plus the skim milk would bring the same price as the
whole milk.
The essence of the argument is that increasing the amount of debt
(cream) lowers the value of outstanding equity (skim milk) – selling
off safe cash flows to debt-holders leaves the firm with more lower valued equity, keeping the total value of the firm unchanged. Put
differently, any gain from using more of what might seem to be cheaper debt is offset by the higher cost of now riskier equity.
Hence, given a fixed amount of total capital, the allocation of capital between debt and equity is irrelevant because the weighted
average of the two costs of capital to the firm is the same for all possible combinations of the two.
I (^) There are two types of agents, i = 1 , 2.
I (^) Future payoff-relevant state, s 2 S.
I (^) Probability that state s takes place, ⇡(s). (⇡(s) 0, P s 2 S ⇡(s) =^ 1). I (^) Endowment of agent i in state s, y i^ (s).
I (^) Consumption of agent i in state s, ci^ (s).
Let ci^ = {ci^ (s), for all s 2 S}.
I (^) Payoff of an agent
U(ci^ ) =
s
us (ci^ (s))⇡(s),
where us (·) is increasing and concave, with
limc# 0 u^0 s (c) = + 1.
I (^) The planner’s solution:
max (c^1 ,c^2 )