Article Detail

Computational Corporate Finance

Journal 33: Technical Finance

Kosrow Dehnad

This article proposes using market data and computationally intensive methods to explore various topics in corporate finance. It uses such techniques to demonstrate that the capital structure of a company has a bearing on its valuation because it plays a major role in its survival. This result differs from the original Modigliani-Miller assertion that the capital structure of a company should not impact its valuation. It is shown that for a given level of business risk, in order for the firm to survive with a high degree of confidence, its leverage should not exceed a certain limit – maximum acceptable leverage. Another computationally intensive technique is proposed as a complement to the net present value (NPV) method. This approach eliminates the need for choosing the “proper” discount rate, whose computation seems at times to be more of art than science accompanied with some elements of handwaving.

The field of corporate finance has witnessed major advances in the past decades. Many of these advances, however, have been made before the onset of the information age that has provided researches with cheap computing power and access to information and market data that till then were not easily available. During this time, researchers had to make some simplifying assumptions in order to render problems tractable. However, when these simplifications were carried to an extreme, such as assuming that leverage does not significantly impact the survival of a firm, and hence its credit spread and cost of capital, the results derived by researchers, though interesting and at times intriguing, were clearly unrealistic from a practical point of view. A case in point is the original version of the Modigliani-Miller theorem that concludes that the capital structure of a company should not impact its valuation. This paper uses computational techniques to show that the above statement does not hold even in the case of a firm with a simple operational model. The computational approach is also used to present an alternative/complement to net present value (NPV) techniques. NPV was also developed in an era when, due to lack of computing power, it was very difficult to study the risk and return of projects under various scenarios covering different yield curves, market conditions, and business cycles. Instead, in NPV, all the above risks are to be encapsulated into a “proper” choice of discount rate. The selection of this rate at times becomes more of an art than science and sometimes requires some handwaving, such as appealing to comparable projects, etc. Once again, using market data and computation, one can estimate the risk and return of a project and compare this risk/return profile with other investment opportunities in the market. Computationally intensive methods can enhance our understanding of the impact of various economic factors on the finances of a corporation and provide practical tools to help managers make better financial decisions. This article uses a simple model to illustrate the aforementioned points.

Capital structure and value of a firm

In studying the impact of capital structure on the valuation of a company we first address the following question: does the survival of a firm (avoiding bankruptcy) depend on its capital structure? To answer this question we start by developing a model to represent the workings of a simple firm and use it to study the effects of capital structure on its survival. The study shows that even in the case of a simple company, the survival of the firm does depend on its capital structure. And it goes without saying that in the real world with so many factors and constraints, it is unrealistic to assume that the value of the firm is independent of its capital structure. In fact, lenders are well aware of the fact that leverage renders a firm more risky and demand a higher borrowing spread when lending to companies that are more leveraged, which in turn increases their cost of the borrowing and could make it more difficult for them to access the capital markets. And these consequences, in turn, increase the likelihood of financial distress. This model reflects this reality and quantifies the impact of leverage on the probability of default and hence the credit spread. The model also contrasts with the discounted dividend equity valuation that assumes a company will operate forever and will provide a never ending stream of dividends for its equity holders – contrary to what is observed in the real world.

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