Effects to the corporations in

taking more debts/equity

during a global crisis
And the strategies that best suits during
a crisis

Sana Abdulla/BIBF-B04/IUM-3455
Corporate finance Sana Abdulla/IUM-3455 BIBF-B04

Table of Contents
Introduction: ............................................................................................................................................ 2
Effects to the corporations in taking more debts/equity during a global crisis: .......................................... 3
Strategies that best suits under a crisis: .................................................................................................... 9
1. Expansionary fiscal policy: .......................................................................................................... 9
2. Expansionary monetary policy ..................................................................................................... 9
3. Giving subsidies to infant industries, and primary sector firms. This ............................................. 9
4. Review and edit the budget .......................................................................................................... 9
5. Keep a good track of its debt ........................................................................................................ 9
6. Keep track of their cash flows .................................................................................................... 10
Conclusion: ........................................................................................................................................... 11
References............................................................................................................................................. 12

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Introduction:
As stated by (Wensbury, 2015), a global crisis is an extremely difficult time for all the countries
in which the financial institutions, markets, companies and consumers are affected negatively. The
2008 financial crisis is an example of this.

During this time, the price or worth of the financial assets decrease immensely. Many businesses
and banks collapse as they are not able to survive in the harsh market. The banks are also not
willing to lend to customers or businesses like they used to, as the credit worthiness of them reduce.
The banks would want early settlement of loans. Due to this situation in the world economy, the
governments offer a lot of their support in different forms to assist the businesses and customers.

The corporations and banks might try to borrow and increase their equity or their capital structure
to survive if a crisis were to occur again. Capital structure is the combination of funds in the
company; they include both the debt and equity portion of the company. If they were to increase
these during a crisis, they are to face many consequences due to it.

If the corporations somehow manage to increase their debt or equity during this time, they would
have difficulty repaying the debt. They may not be able to pay returns to investors. Thus they
might sell the shares or might leave the company.

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Effects to the corporations in taking more debts/equity during a global

crisis:
1. During a crisis, the stock price would decrease, low profit due to reduced demand may
make it difficult to give out a good dividend. The less number of people who wish to invest
would also rather choose risk less government bonds than companies. According to (Roger
G.ibbotson, 2018), investors are risk-averse and the largest risk premium is the equity risk
premium as the expected return from it is higher than that of risk free assets and bonds.
Thus it will be a challenge for the companies to raise good equity during a crisis. When the
risk increases, cost of equity decreases.
This can be proved using the capital asset pricing model (CAPM) by Harry Markowitz.
Under this theory, it is believed that there are two types of risks; systematic risk (market
risk; risk that cannot be diversified) and unsystematic risks. This can be used to calculate
the price of risky assets, or a portfolio of assets. As stated by (Wilkinson, 2013), expected
return = Risk-Free Rate + Beta (Market Return _ Risk-Free Rate). [(Ra)=Rf+ β(rm_rf).
The expected return is the addition of risk premium and a risk free rate. The risk premium
is the incremental return from a risky asset’s investment while the risk free rate is the return
from a risk free investment such as investing in a government bond. Beta calculates the
sensitivity of an asset according to the movements in stock market; if the beta is > 1, stock
is riskier and if beta is < 1, the risk is low.
For instance, if the beta of a company is 0.95, the risk-free rate is 5.5 percent and the
expected return in the market is at 10%, the company’s cost of equity would be:
5.5 + 0.95 (10 _ 5.5) = 9.78% (risk premium is at 4.5)
Now, if the risk increases due to the crisis, say, to 7 (the expected return is at 8) the cost of
equity would be as follows:
5.5 + 0.95 (8 _ 5.5) = 7.88% (the cost of equity decreased by 1.9% when the risk premium
increased by 2.5).

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2. However, they might have constructed a portfolio that consists of many assets starting from
very low risk all the way to high risk; thus the risk will be lower than individual assets
when combined like this and the money being spread across different types of assets like
bonds and stock. This is the concept underlying Markowitz’s modern portfolio theory.
Harry Markowitz pioneered this theory in ‘portfolio selection’ in 1952. He believes that
the portfolio of investments must be based on ‘the efficient frontier’
According to (Thune, 2020), bonds and stock are negatively correlated; (correlation is the
degree to which two securities (variables) move in relation to each other. When both the
securities move in the same direction, the co-efficient is 1 and it is a positive correlation
and vice versa). Therefore, a portfolio which consists of two or more securities like this
would minimize the losses that arises in the portfolio when one asset goes down. This way,
the company might have maximized its return and maybe able to give a return to the
shareholders as well.
For instance, the company has, say, 2 asset portfolio that is worth $100000 and had invested
$80000 in an asset and $20000 in the other asset; the expected return of the heaviest-
weighted asset is 6% and the other a 12%.
Expected return of asset A = 80000/100000×6%
= 4.8%
“B = 20000/100000×12%
=2.4%
So the expected return of the portfolio = 4.8 + 2.4 = 7.2
Now if the company wishes to increase the expected return from the portfolio, say, to 9%.
This is possible by moving some capital from the low-invested asset to the heavily-invested
one. So:
50%×6% = 3%
50%×12% = 6%
(equally investing in both assets result in 9% expected portfolio return in this case)
The company can also increase/decrease risk in the portfolio. According to (Miller, 2019),
this can be done using beta ( a statistic that calculates the systematic risk of the market).
Beta > 1 = risky asset and beta < 1 = low risk and thus decreased portfolio risk as well.

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Now let’s say that the portfolio of the company has 4 assets instead of 2 and has invested
the $100000 equally as 25% for each asset. And:
Beta of asset A = 1
“B = 1.7
“C = 0.80
“D = 0.6
So (25% ×1) + (25% ×1.7) + (25% ×0.80) + (25% × 0.6) = 1.025 (beta more than one, thus
risky).
If the company wants to increase the risk further in order to increase the return, the
weighting of the 4 assets can be adjusted in such a way that will allow the company to
achieve the beta company wants, say, 1.3.
The asset B has the highest beta, thus the greatest chance for getting a higher return.
Therefore, 10% from each asset, A, C and D can be shifted to asset B. Thus:
Beta of asset A = 15% ×1 = 0.15
“B = 55% × 1.7 = 0.935
“C = 15% × 0.80 = 0.12
“D = 15% × 0.6 = 0.09
Portfolio beta = (0.15 + 0.935 + 0.12 + 0.09) = 1.295
Therefore, the company could survive by adjusting the portfolio risk and return and
maintain a good equity and achieve investor’s satisfaction as well, if managed well.
3. The preposition 1 of M&M theory (by Franco Modigliani and Merton Miller in 1958)
assumes that there are no tax/asymmetric information/bankruptcy costs. The market value
of firm would not be affected even if the debt or equity is increased. Since the market value
is calculated using the present value of future cash flows (outstanding shares × current
stock price), the value of the leveraged and unleveraged firm is the same. According to
(William Carlson, 2016), a 100% leveraged company will not benefit from any tax-
deductible interest payments.
However, the sales, customer loyalty, share price, ease in getting investments etc. are likely
to remain the same as market value is not affected. But since the debt/equity is increased
during a crisis, these effects are prone to be negative. The sales may reduce, the firms are
likely to not get much investments and the companies would have to reduce the share price.

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Here is a numerical example of market value remaining the same with increase in
debt/equity as explained by (MM prepositions 1 and 2 (case with no taxes), n.d).
Possible outcomes (next year) for Firm A:
Firm A Normal Recession Boom
Probability for next 1/2 1/8 3/8
year
Operating income 250 100 300
Earnings per share 2.5 1 3

_ the shares outstanding = 100

_ required rate of return = 12.5%

_ expected EPS: 1/2×2.5 + 1/8×1 + 3/8×3 = 250

_ value of 1 share in firm A: PA = EPS/r

= 2.5/.125

= 20 dollars

_ total value = VA = 100 PA = 2000 dollars

Say, firm B (which has 12.5% of required rate of return and 100 shares outstanding as
well). They issue a debt worth of 1000 dollars at a risk free rate of 10% and uses its profits
to rebuy shares. They buy 50 shares using that 1000 dollars thus now they have 50 shares
which are outstanding. So:

Firm B Operating Interest Earnings on EPS

income equity

Normal 250 100 150 3

Recession 100 100 0 0

Boom 300 100 200 4

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Let me prove that the value of firm B is exact to firm A. say, the new capital structure of
firm B increases its value. So VB > 2000 dollars. Two strategies can be used to prove it.
they have different initial outlays and equal future cash flows.

1. Purchase 1 share in firm B so VB _ value of debt / # of shares is more than 1000

dollars/50; This is equal to 20 (cost)
Cash flows:

Boom Recession Normal

Dividend on firm B 3 4 0

2. Purchase 2 shares in firm A & take 20 dollars as debt on a risk free rate which will be
paid in equal installments of 2 dollars in perpetuity.
40 _ 20 = 20 (cost). These are the cash flows:

Dividend on firm A Payback Total

Normal 5 _2 3

Recession 2 _2 0

Boom 6 _2 4

All of the investors will go for the cheaper strategy, 2 strategies will not exist in an
equilibrium. So shares of firm B will not be bought by any investors. Thus the value of it
would reduce till 2000 dollars. Hence proved that changes in capital structure will not affect
the market value.
However, in the real world, companies pay taxes. Thus, in preposition 1 (with taxes), its
stated that the value of a leveraged firm is higher than that of an unleveraged firm because
of the tax shields from tax deductible interest payments as said by (Borad, 2019). These
tax shields affect the cash flows of a company positively as the market value is calculated
using the present value of future cash flows. Therefore, increasing the borrowings might
affect the cash flows of the company positively even during a crisis.

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According to preposition 2 of M&M theory, the leverage level of a firm is directly

proportional to the cost of equity (return); an increase in debt/borrowing would result in an
increase in the default probability of the company. Thus, investors would demand an
increase in return compensating for the increase in risk. However, during a crisis, paying a
high return for the investors may not be easy. Thus, they may not be satisfied and might
invest in risk free bonds etc. instead.
Here is how the leverage level and cost of equity are directly proportional explained
numerically as per (MM prepositions 1 and 2 (case with no taxes), n.d).
Firm A (all Required rate value Expected Appropriate
equity firm) of return perpetuity discount rate for
firm B
12.5% $2000 $250 12.5% ($2000 =
250/r) so if firm
B is all equity
12.5 is the rate
of return
(applies to all of
firm B’ assets.)

Since firm B is leveraged, WACC is used to find the cost of capital.

ro = D/(D+E) rD + E/(D+E) rE
multiplying 2 sides by (D+E)/E: (D+E)/E ro = D/E rD + rE
Rearranging it = preposition 2: rE = (D+E)/E ro _ D/E rD
= ro + D/E ro _ D/E rD
= ro + D/E (ro_rD)
Here, rE = .125 + $1000/$1000(.125_.10) = .150
So the equity for firm B
However, in preposition 2 (with taxes), its stated that even though the leverage level and
cost of equity are directly proportional, the cost of equity is less sensitive to the level of
borrowing when taxes are paid.

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Strategies that best suits under a crisis:

1. Expansionary fiscal policy:
Under this, government could reduce taxes and increase the government expenditure.
When taxes such as GST, income tax is reduced, the household income would increase,
thus spending would increase, raising the aggregate demand and GDP. Moreover, since
businesses have to pay lesser amounts of profit tax, their reserves will increase and they
will be encouraged to increase investments. They might also be able to give the investors
a good return. As a result, the risk for the investors might decrease in the long run as the
cost of equity (return) increases.
2. Expansionary monetary policy: here, government could reduce the interest rates and
increase the money supply. According to (Amadeo, 2019), lowering the interest rates
would result in more spending rather than saving. The reduced prices of loans would also
encourage the businesses to borrow more to finance their investments and to meet the
demand of the consumers. Thus, they might have to hire more employees resulting in even
higher income and spending. All of this would lead to a stimulation of the aggregate
demand, lending a hand with fighting the crisis.
3. Giving subsidies to infant industries, and primary sector firms. This will allow them
to lower their cost, and increase their production; assisting them to compete in the market
with the bigger firms. Moreover, more people would be interested in starting businesses
due to government grants. The number of small firms would increase leading to more
competition, lowered prices and increased output. Subsidies to primary sector businesses
such as farmers would allow higher production and would assist in lowering the imports.
4. Review and edit the budget. They can shift some allocated money from some sectors to
vital ones during a crisis. Such as reducing the budget on sports perhaps, to that of subsidies
and public goods or infrastructure.
5. Keep a good track of its debt as during a crisis, the income for the government will
reduce immensely due to lowering tax rates and increasing the expenditure. Therefore, it
may be difficult to pay back the loans in the short run. This will allow the government to
not use so much money on interest rates of the loans and spending it to recover the
economy.

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6. Keep track of their cash flows. As for the firms, this is very important. They could try to
get an overdraft till the cash flows are good again as the trade receivables etc. may not be
able to pay the money during a crisis.

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Conclusion:
Even though a global crisis is very hard to come out from and to recover the economy back to
normal is even harder, these theories such as modern portfolio and M&M theory shows that the
companies can survive if they manage well. Taking more debt and equity maybe difficult during
this time but with the help of the government and with the appropriate measures at the right time,
they will be able to survive and recover. The effects however, might take some time to show and
the real positive impacts could occur only in the long run.

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References
Amadeo, K. (2019, December 20). Expansionary Monetary Policy. Retrieved from thebalance.com:
https://www.thebalance.com/expansionary-monetary-policy-definition-purpose-tools-3305837

Borad, S. B. (2019, April 25). Capital structure theory _ Modigliani and Miller (MM) approach. Retrieved
from efinancemanagement.com: https://efinancemanagement.com/financial-leverage/capital-
structure-theory-modigliani-and-miller-mm-approach

Miller, T. (2019, March 22). What is Modern Portfolio Theory (MPT) and Why is it Important? Retrieved
from thestreet.com: https://www.thestreet.com/investing/modern-portfolio-theory-14903955

MM prepositions 1 and 2 (case with no taxes). (n.d). Retrieved from finance.wharton.upenn.edu:

http://finance.wharton.upenn.edu/~jwachter/fnce100/h13.pdf

Roger G.ibbotson, T. M. (2018, December 10). Popularity: A Bridge between Classical and Behavioral
Finance. Retrieved from cfainstitute.org:
https://www.cfainstitute.org/en/research/foundation/2018/popularity-bridge-between-
classical-and-behavioral-finance?s_cid=ppc_RF_Google_Search_PopularityCAPM

Thune, K. (2020, March 21). What is Modern Portfolio Theory (MPT)? Retrieved from thebalance.com:
https://www.thebalance.com/what-is-mpt-2466539

Wensbury, B. (2015). Global Financial Crisis. Retrieved from marketbusinessnews.com:

https://marketbusinessnews.com/financial-glossary/global-financial-crisis/

Wilkinson, J. (2013, July 23). Capital Asset Pricing Model. Retrieved from strategiccfo.com:
https://strategiccfo.com/capital-asset-pricing-model/

William Carlson, C. L. (2016, january). Can business firms have too much leverage? M&M, RJR 1990, and
the crisis of 2008. Retrieved from researchgate.net:
https://www.researchgate.net/publication/295901830_Can_Business_Firms_Have_Too_Much_
Leverage_MM_RJR_1990_and_the_Crisis_of_2008

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