7. Capital Structure (Part 3) Flashcards
What are some methods to reduce bankrutpcy/financial distress costs?
- Reduce amount of debt
- Consolidation of debt
How does consolidation of debt affect bankruptcy costs and why?
One reason banktrupcy costs are so high is that different creditors (and their lawyers) contend with one another. If one or at most a few lenders shoulder the entire debt, the negotiating costs are minimised when financial distress occurs.
What are some methods to reduce agency costs of debt?
- Use of protective covenants.
- Bondholders owning some equity. This way shareholders and debtholders are not pitted against one another because they have shared interests (they are not seperate entities).
What is the Pecking Order Theory?
A theory which explains why firms do not always follow the trade-off approach in practise.
Companies prefer to obtain financing in the following order, starting from the safest security to the riskiest (last resort) option:
1. Internal financing (e.g., retained earnings)
2. Debt/bonds (very safe debt first, then risky debt, then convertible bonds)
3. New issue of equity
What is the usual market response to new equity issues and why?
New equity issues are usually met with a negative market response (reduction in share market price).
A company’s managers are better informed about a company’s prospects than outside investors. If managers want to offer new shares (at current market price), investors may expect that the company believes its shares to be overvalued and thus that they should not invest. This is because managers and existing shareholders would be negatively impacted by selling undervalued shares as they would receive less cash for them than they’re actually worth. Whereas managers and existing shareholders would profit from selling overvalued shares. Because of this, anytime a company attempts to obtain financing through a new offering of equity, investors infer that this firm is among the most overpriced, causing the shares to fall more than is deserved. Thus, the end result is that virtually no one will issue equity.
Why can debt issue be inferred by investors as an indicator of a current overvaluation of debt (e.g., bonds)?
Because due to the asymmetric information between managers and external investors, managers have a better understanding of the company’s chance of default (i.e., if their debt is overvalued). Managers/shareholders will be better off (or be more incentivised to) issuing debt if their debt is overvalued. Investors are aware of this and thus are sceptical about investing in new corporate debt.
However, the price scepticism impacts bonds to a lesser extent than equity, so managers rely first on bond financing as an external financing method (if internal financing is not an option). Debt financing is also preferred over equity financing due to lower transaction costs.
How do companies overcome the scepticism from investors associated with the issue of new equity and debt ?
By financing projects using retained earnings (internal financing).
Thus, the first rule of the pecking order is to use internal financing.
What are the implications of the pecking order theory?
- There is no target amount of leverage. Instead of choosing a leverageratio based on balancing the benefits and costs of debt (trade-off), managers choose the leverage ratio based on financing needs.
- Profitable firms use less debt.
- Companies like financial slack (having free cash flow). However it is important to note that there are negatives to managers sitting on a lot of cash.
How does debt in a company’s capital structure reduce the net agency costs of equity?
Debtholders often impose covenants and closely monitor the company’s performance which reduces the ability of managers to engage in self-serving behaviour or invest in projects that do not maximise shareholder value. Also debt introduces the obligation to make interest and principal payments which reduces the free cash flow available to the company and introduces the threat of financial distress, both of which increase the discipline required by managers when utilising available cash.
Good corporate governance and accounting transparency.
