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Lecture 4: Financial Assets and Capital Structure

Quiz Review and Financial Assets​

Financial Assets vs Real Assets​

Key Question: What are examples of financial assets?

Financial Assets (represent claims on real assets):

  • Government bonds
  • Corporate bonds
  • Stock index funds
  • Stock options
  • Corporate debt

Real Assets (produce goods/services):

  • Land
  • Real estate
  • Equipment
  • Buildings

Simple Rule: If it produces something directly, it's a real asset. If it represents ownership or a claim, it's a financial asset.

Investment Banks vs Commercial Banks​

Investment Banks:

  • Help companies raise capital by selling securities
  • Underwrite new stock/bond offerings
  • Provide M&A advisory services
  • Don't take deposits

Commercial Banks:

  • Handle deposits and loans
  • Take deposits from customers
  • Make loans to individuals and businesses
  • Regulated differently than investment banks

Credit Unions:

  • Non-profit organizations
  • Members-only (employees of specific companies, residents of specific areas)
  • Use member deposits to lend only to other members
  • Any "profit" distributed back to members

Agency Problem Mechanisms​

Question: What mechanisms mitigate agency problems between shareholders and managers?

Effective Mechanisms:​

  1. Stock Options: Align manager compensation with stock performance
  2. Management Replacement: Board can fire underperforming managers
  3. Security Analyst Monitoring: External analysts monitor company performance
  4. Takeover Threats: Poor performance makes company acquisition target

Ineffective Mechanisms:​

  • Nepotism: Hiring family members doesn't solve agency problems
  • Anti-takeover Provisions: Protect management, not shareholders

Primary vs Secondary Markets​

Primary Market​

  • Definition: Trading of newly issued securities
  • Process: Company → Investment Bank → Investors
  • Money Flow: Money goes to the issuing company
  • Example: IPO (Initial Public Offering)

Secondary Market​

  • Definition: Trading of previously issued securities
  • Process: Investor A → Market → Investor B
  • Money Flow: Money flows between investors
  • Example: Buying Tesla stock on Robinhood

Key Insight: In secondary markets, the company doesn't receive any money from the transaction.

Capital Structure Example​

Business Setup​

Scenario: Partnership to invest in S&P 500 index

  • Initial Capital: $20 million (equity)
  • Debt Financing: $80 million
  • Total Investment: $100 million in S&P 500
  • Time Horizon: 1 year

Capital Structure Details​

Senior Debt:

  • Face Value: $40 million
  • Coupon Rate: 8%
  • Coupon Payment: $3.2 million
  • Total Payment: $43.2 million (face value + coupon)
  • Priority: First to be paid

Junior/Subordinated Debt:

  • Face Value: $40 million
  • Coupon Rate: 20%
  • Coupon Payment: $8 million
  • Total Payment: $48 million (face value + coupon)
  • Priority: Second to be paid

Equity:

  • Initial Investment: $20 million
  • Priority: Last to be paid (residual claimant)

Payment Waterfall Analogy​

Think of payments like a waterfall with buckets:

  1. Senior Debt Bucket: 43.2 liters capacity
  2. Junior Debt Bucket: 48 liters capacity
  3. Equity Bucket: Unlimited capacity (gets remaining water)

Payment Order:

  1. Fill senior debt bucket completely
  2. Fill junior debt bucket completely
  3. Remaining water goes to equity holders

Payoff Functions and Risk Analysis​

Scenario Analysis​

Scenario 1: S&P 500 +20% (Assets = $120M)

  • Senior Debt: Receives $43.2M (8% return)
  • Junior Debt: Receives $48M (20% return)
  • Equity: Receives $28.8M (44% return)

Scenario 2: S&P 500 0% (Assets = $100M)

  • Senior Debt: Receives $43.2M (8% return)
  • Junior Debt: Receives $48M (20% return)
  • Equity: Receives $8.8M (-56% return)

Scenario 3: S&P 500 -20% (Assets = $80M)

  • Senior Debt: Receives $43.2M (8% return)
  • Junior Debt: Receives $36.8M (-8% return)
  • Equity: Receives $0M (-100% return)

Key Insights​

Leverage Effect:

  • Equity return is more sensitive to asset value changes
  • Debt returns are capped by coupon rates
  • Equity has unlimited upside but limited downside (to zero)

Risk-Return Trade-off:

  • Senior Debt: Lowest risk, lowest return
  • Junior Debt: Medium risk, medium return
  • Equity: Highest risk, highest potential return

Payoff Functions (Mathematical)​

Senior Debt Payoff:

Payoff=min⁡(Asset Value,43.2)\text{Payoff} = \min(\text{Asset Value}, 43.2)

Junior Debt Payoff:

Payoff=min⁡(max⁡(Asset Value−43.2,0),48)\text{Payoff} = \min(\max(\text{Asset Value} - 43.2, 0), 48)

Equity Payoff:

Payoff=max⁡(Asset Value−91.2,0)\text{Payoff} = \max(\text{Asset Value} - 91.2, 0)

Default and Bankruptcy​

When Assets < Total Debt ($91.2M):

  • Equity value = 0 (limited liability)
  • Debt holders become new owners
  • Absolute Priority Rule: Senior debt paid first, then junior debt
  • Stockholders lose everything but don't owe additional money

Key Concept: Limited liability protects shareholders from personal losses beyond their initial investment.

Key Takeaways​

  1. Financial vs Real Assets: Financial assets represent claims; real assets produce goods/services

  2. Agency Problem Solutions: Stock options, takeover threats, analyst monitoring, and board oversight

  3. Market Types: Primary markets fund companies; secondary markets trade existing securities

  4. Capital Structure: Different securities have different risk-return profiles and payment priorities

  5. Leverage Effect: Equity is more sensitive to asset value changes than debt

  6. Limited Liability: Shareholders' losses are limited to their initial investment

  7. Payment Priority: Senior debt → Junior debt → Equity (residual claimant)

  8. Risk-Return Trade-off: Higher priority = lower risk = lower return potential