6. Corporate finance

Question 1

“Capital structure”

If managers act in the interests of stockholders, then when facing the risk of default, they will tend to transfer value from creditors to debtors. Name 4 ways to do it.

Do creditors know about it and do they try to avoid it?

Answer 1

1. Investment in riskier assets/risk-shifting/overinvestment → increase the “upside” for stockholders, the “downside” is absorbed by the firm’s creditors
2. Borrow more/cash out → pay out cash to stockholders
3. Debt overhang/underinvestment → cut back equity financed capital investment (the greater the risk of default, the greater the benefit to existing debt from additional investment)
4. “Play for time” → managers conceal problems to prevent creditors from acting to force immediate bankruptcy.

Debt investors (creditors) are aware of the conflicts and try to avoid them by writing contracts properly → debt covenants restrict additional borrowing, limit dividend payouts and other distributions to stockholders, and provide that debt is immediately due and payable if other covenants are seriously violated

Question 2

“Empirical capital structure: a review”

What are determinants of target leverage?

Answer 2

1.
Tax Exposure (tax rate↑ → debt↑)
Interest Tax Shield = Corporate Tax Rate * Interest Payments

2. Cash Flow Volatility (volatility↑ → debt↓)
   • Traditional and intuitive argument: high volatility -> high probability of bankruptcy -> should use less debt
   • Bankruptcy is more likely to occur during bad times -> firms with higher systematic risk will have lower debt ratios
3. Size of the company (size↑ → debt ↑)
   • Fixed costs of refinancing are higher for smaller firms
   • No “pure” size effect - firm size is correlated with a number of omitted factors that influence borrowing costs (ex., larger firms are more diversified, have lower volatility and higher cash flows) -> lower probability of bankruptcy → allows larger firms to take on more debt
   • Large firms → easier to raise cash by selling assets in case of distress
   • Large firms → banks are more willing to provide credit (better reputation), better access to debt markets
4. Asset tangibility (FA/TA ↑ → Debt↑)
   • most common rationale: tangible assets better preserve their value during default, and as such, increase the recovery rates of creditors
   • related idea: in case of default, the costs of redeploying tangible assets is lower than for intangible assets
   • Intangible assets have subjective and different value for all the potential bidders + FA are easier to use in other industries
5. Market to book value ratio (M/B ratio ↑ → Debt ↓)
   • Firms with high M/B ratio → good future prospects/growth opportunities → use internal financing to fund those growth opportunities
   • Firms with high M/B ratio → overvalued equity → an incentive to use more equity financing because it is favorably priced
6. Product Uniqueness (Uniqueness ↑ → Debt ↓)
   • Firm’s nonfinancial stakeholders are more likely to be concerned about the financial health of more unique firms as liquidation imposes significant costs on its workers, customers, and suppliers -> don’t want the firms to take on a lot of debt
7. Industry Effects (Competition ↑ → Debt ↓)
   • Debt reduces the flexibility of operations (constant payouts required) -> firms operating in competitive industries prefer to keep low debt ratios
8. Firm Fixed effects
   • Number of factors such as managerial preferences, governance structure, geography, competitive threats, “corporate culture,” and so on, can affect debt ratios, but it is hard to measure them

Question 3

“Corporate payout policy”

What are the factors stimulating and retaining payouts?

Answer 3

Factors stimulating payouts:
• investors pressure managers to accelerate cash payouts (avoid wasteful investment & managers’ personal benefits)
• managers have incentives to build a reputation for treating investors fairly in their payout decisions to be able to sell future equity at higher prices
• firms generating large amounts of FCF are “sitting ducks” for takeovers by activist investors

Factors retaining payouts:
• agency problems – managers make decision to keep cash • tax advantages of deferred payouts

Question 4

“Corporate payout policy”

Name 6 reasons for high dividends.

Answer 4

1. Lower agency costs → fewer opportunities for wasteful investment
2. Low growth companies → mature companies with a lack of good investment prospects (only zero/negative NPV projects available) → lifecycle theory
3. Signaling theory → dividends signal firm’s future performance (try not to cut dividends to avoid a decrease in share prices because of information asymmetry)
4. Bird in hand theory→ if investments are highly uncertain, shareholders will prefer the money to rather be paid put as dividend than invested (desire for current income)
5. Clientele effect → attract investors who are interested in high dividends payouts (ex. companies facing low taxes)
6. Trading costs → costly to replicate dividends payouts (“homemade” dividend)

Question 5

“Corporate payout policy”

Name 4 reasons for low dividends.

Answer 5

1. Costs of financial distress (rather sit on cash than deal with costs of financial distress due to defaulting on debts – rather for highly leveraged companies)
2. Good growth prospects → positive NPV investment opportunities → typically for younger firms → lifecycle theory
3. Personal taxes of shareholders → dividends are mostly than capital gains, use repurchases trying to minimize taxes for shareholders
4. Clientele effect → trying to attract tax-conscious investors who care about paying high taxes on dividends

Question 6

“Corporate payout policy”

What are the advantages of stock repurchase?

Answer 6

1. Financial flexibility
   • do not lock managers into an implicit commitment to continue distributing the same or a greater amount of cash in future periods
   • Allow to reduce the level and frequency of payouts
2. Correct stock market valuation
   • repurchase stock when firm’s shares are undervalued
   • managers exploit stockholders by repurchasing stock prior to periods of significant share appreciation (arguable)
3. Remove low valuation stockholders
   • A means of increasing the value of the managers’ personal stake
   • Avoid a takeover → low valuation stockholders are eager to sell their shares cheaply 4. Allocation of voting rights
   • • •
   remove a threatening large block stockholder
   increase managers’ percentage ownership of voting rights Remove low valuation investors
4. Increase reported EPS
   • Mechanical increases in EPS simply due to fewer shares
   • Improved operating performance following stock repurchases
5. Save transaction costs
   • reducing the number of shareholders, the firm is able to reduce its investor relations expenditures,
   • the costs of annual report and proxy mailings, responding to inquiries about company performance, etc.
   • Likely to be important only for small firms
6. Provide liquidity to investors who want to sell shares