Equity Valuation and Portfolio Management

TRADITIONAL CAVEATS

The link between FSR and CAPM provides a natural transition to the VBM approach to company analysis. We provide that discussion later in the chapter. However, as a cautionary word on the traditional role of corporate debt policy, it may seem odd that investors should somehow feel better off with higher amounts of leverage, even though the firm's return on assets (or capital) remains constant. This comment points to a hopefully obvious limitation of the traditional approach to company analysis. That is, unless the corporate debt change is associated with a rise in real profitability (due to cash-flow benefits received from a higher debt-interest-tax subsidy) or a perceived decline in equity risk (when a firm moves from a position of too much debt back to its presumed target level), then nothing of any real significance has changed for the shareholders. Without a meaningful change, investors have little incentive to pay a higher or lower price for the firm's shares due to corporate leverage changes per se.

Moreover, in a special case of the VBM approach to capital structure (namely, the original 1958 capital structure model developed by Modigliani and Miller²), the perceived stockholder benefits resulting from higher leverage are offset by a rise in the expected (required) rate of return on the firm's common stock. We discuss the comparative valuation effects of capital structure in the next section.