Preparation Questions for Myers & Majluf Article on Financing and Investing Decisions
Tradicional Finance
a) If the NPV of the project is positive, the firm should undertake the investment.

b) Base in the formula I = E + S we can demonstrate what is the best decision for the company. For that we will make a numerical example.

State 1 State 2 Asset-in.place a 150 50 Investment Opportunity (NPV) b 20 10 P' I Debt (D) Lot of cash S E True Value (V) P'+E V V old new

= = =

115 150 0

115 150 0

= = = = =

100 50 320 165

100 50 210 165

= 223,03 146,36 96,97 63,64

Little cash S E True value (V) P'+E V V old new

= = = =

30 120 320 235

30 120 210 235

= 156,60 102,77 = 163,40 107,23

S↗

S↘

Payoff V in state 1 V in state 2 old old

Issue & Invest (E=50) 223,03 146,36

Issue & Invest (E=120) 156,60 102,77

Do nothing (E=0) 150 50

With this example we can easily state that more cash bring more value to the old stockholders and most importantly, to the firm.

c) Retained earnings – could avoid to issues stocks (assumption: the firm only uses risk-free borrowing to reduce the required investment and the investors are passive). “Firms should go to bond markets for external capital, but raise equity by retention if possible.” (Page 219 of the paper). Firms can build up financial slack by restricting dividends when investment requirements are modest. The cash saved is held as marketable securities or reserve borrowing power.

Debt – makes possible to create value through tax benefits and by the non-necessity of revealing proprietary information to competitors, only to a financial institution (bank). The bank could then finance a new project on terms which are fair to old stockholders. New Equity – the best time line to issues stocks is when the firm is overvalued or the market value equal the true value of the