Value, Capital Structure and Cost of Capital: A Theoretical Framework

In this chapter, we discuss the implementation of an asset-side approach in order to overcome the problems of the equity-side models. Unlike non-financial firms, bank deposits generate value. Such an effect is explored by several empirical studies concerning the relation between capital requirements and the weighted average cost of capital (WACC) and, consequently, on a bank’s value. Moreover, in this chapter, we use such empirical evidence to highlight the problems related to the applicability of Modigliani and Miller propositions to the banking industry. Specifically, the main concern of this chapter is to build a new corporate finance theoretical framework for bank valuation, exploring a new issue that represents a relevant gap in the literature. Using the theoretical framework, we elaborate the AMM to highlight the value generated from the unlevered assets, deposits and tax-shields. To do this, we formalize the link between the cost of assets and the WACC, and propose a restatement of the Modigliani and Miller propositions using bank-specific adjustments. Additionally, we compare and reconcile the AMM to excess returns models.