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Economics 434 Theory of Financial Markets

Economics 434 Theory of Financial Markets. Professor Edwin T Burton Economics Department The University of Virginia. Citigroup. $ 55. From $ 320 Billion to $ 20 Billion. $ 30. $ 20. $ 10. $ 3.77.

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Economics 434 Theory of Financial Markets

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  1. Economics 434Theory of Financial Markets Professor Edwin T Burton Economics Department The University of Virginia

  2. Citigroup $ 55 From $ 320 Billion to $ 20 Billion $ 30 $ 20 $ 10 $ 3.77 May 21, 2007 Jan 2008 10/1 11/17 11/22

  3. The Bailout Details • $ 20 Billion in Cash as a “preferred equity’ with an 8 % coupon • $ 306 Billion “bad bank” • Citi issues $ 7 B preferred with 8 coupon as fee to Treasury • Citi has first loss of $ 29 billion; 90/10 split on the balance • Other • Reduce dividend to one cent • Exec comp reviewed by govt • Make foreclosure deals

  4. On to “accounting” Balance Sheet Liabilities Assets New Worth

  5. Plus • Revenues • A • B • C • Expenses • D • E • F • Net Income • Taxes • Net Income after Taxes Income Statement

  6. Bal Sheets & Inc Statements are linked Bal Sheet Bal Sheet Date 1 Income Statement Date 2 (Period from Date 1 to Date 2)

  7. Back to the Balance Sheet Balance Sheet Liabilities Assets New Worth

  8. The “No-Arbitrage” Principle • Does not require “equilibrium • Means • Cannot make something out of nothing • Cannot make an infinite amount out of a finite investment

  9. Balance Sheet Liabilities Assets Net Worth Modigliani Miller Theorems on Leverage

  10. Value of the Firm According to Modigliani-Miller • Net Worth • Plus Liabilities In other words, ASSETS !!!

  11. MM-1 In a world of no taxes “Value of the Firm” Is independent Of the leverage ratio Irrelevance of Leverage Theorem

  12. Broader Implications from MM-I • US inadequately levered in the 1960’s • US still relatively less levered that rest of world

  13. MM-II “Cost of equity capital” is a linear function of the debt/equity ratio “Cost of debt capital” is whatever the going interest rate is

  14. Other Famous Modigliani-Miller Theorem • Assume no-arbitrage • Assume no taxes • Should firms pay dividends (or do something else with the cash) • Modigliani-Miller Divd Theorem is • It doesn’t matter • Irrelevance of dividends • But if taxes, then dividends are irrational!!!!!

  15. The End

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