Effect of Corporate Debt on Firm Value

We have shown that three classic works considering the effects of corporate debt on the firm value,namely,Modigliani and Miller(1958,1963),Merton(1974),and Leland(1994),are wrong.Their main mistake is ignoring the business security expenses,BSEs.We suggest the model taking account of BSEs and apply it to the analysis of debt influence on the firm value and survival.Our modeling demonstrates that(1)the debt affects the firm value and its survival,(2)this influence is negative,diminishing the firm value and its chances to survive,(3)the pressure of the negative effect of debt increases as the debt grows,provoking the firm default.The debt can be beneficial for the firm if the loan is taken to improve its technology.The model helps estimate the chances to succeed in the technological modernization for various parameters of the firm and its business environment;and by that,to find the technology most suitable for the firm.It is shown that there is a serious problem in reading the market signals concerning a firm and using this information to control this firm.

No-Arbitrage in Financial Economics: Solution of the Mystery of Implied Volatility and S&P 500 Volatility Index

We have shown that classic works of Modigliani and Miller, Black and Scholes, Merton, Black and Cox, and Leland making the foundation of the modern asset pricing theory, are wrong due to misinterpretation of no arbitrage as the martingale no-arbitrage principle. This error explains appearance of the geometric Brownian model (GBM) for description of the firm value and other long-term assets considering the firm and its assets as self-financing portfolios with symmetric return distributions. It contradicts the empirical observations that returns on firms, stocks, and bonds are skewed. On the other side, the settings of the asset valuation problems, taking into account the default line and business securing expenses, BSEs, generate skewed return distributions for the firm and its securities. The Extended Merton model (EMM), taking into account BSEs and the default line, shows that the no-arbitrage principle should be understood as the non-martingale no arbitrage, when for sufficiently long periods both the predictable part of returns and the mean of the stochastic part of returns occur negative, and the value of the return deficit depends on time and the states of the firm and market. The EMM findings explain the problems with the S&P 500 VIX, the strange behavior of variance and skewness of stock returns before and after the crisis of 1987, etc.

Cumulative Effect of Debt and Tax on Firm Value:Optimal Capital Structure Theories in the Light of EMM

We have shown that cornerstone articles considering effects of corporate debt on the firm value and constituting the basis of the trade-off theory of capital structure are wrong.Their main mistake is in ignoring the business securing expenses(BSEs).In the framework of the extended Merton model(EMM),we consider the cumulative effect of debt and corporate taxes on the firm value and its survival,in other words,we revisit Modigliani-Miller Proposition 3(MMP3).We show that(1)debt affects the firm value and its survival,(2)this effect is negative,diminishing the firm value and its chances to survive,(3)the pressure increases as the debt grows provoking the firm’s default,(4)the main factors depressing the levered firm are its debt payments added to the BSEs of the identical unlevered firm and the length of debt maturity,(5)corporate taxes cause development of positive skewness in the asset distribution,but do not affect the location of this distribution in the asset axis.The presented model helps estimate the consequences of choosing this or that level of debt in the presence of corporate taxes and can make a useful instrument for practicing financial managers.