Capital Structure

Question 1

Modigliani-Miller (1958) Assumptions

Answer 1

1. Perfect and Complete Capital Markets
2. Homogenous Expectations
3. Costless Default
4. No Tax
5. Cashflow independent of capital structure

Question 2

Proposition 1

Answer 2

Firm value is independent of capital structure–> discount rate independent of leverage ratio

Intuition: Firm value given by NPV of expected future cashflows–> how the cashflows are distributed are irrelevant

Otherwise arbitrage opp:
If Va>Vb where (a = 100% equity and b= mix)
would be able to short a and replicate cashflows by purchase B’s equity and debt–> risk free profit

Would get arbitraged away as investors sold A and purchased B

Question 3

Proposition 2

Answer 3

Cost of equity increases with leverage

WACC is independent of D/E only underlying cashflows matter

Intuition:
As Proportion of Equity falls more exposure to business risk–> risk of closing down due to underperformance goes up–> so required return in from E increases

As Proportion of Debt increases claims of cashflow transfers from investors to creditors–> seniority of debt so increases risk of losing investment–> rq rate of return

As D goes up risk debt gets risky:
–> risk of default increases–> expected cost of default increases –> marginal increase in r(e) falls to account for this

–>risk of default increases–> creditors require risk premium to compensate–> marginal increase in r(d) increases

Question 4

Conservation of value principal

Answer 4

W/ Perfect Capital markets financial transactions don’t create or destroy value on transfers it

• -> repackages and redistributes risk and return
• ->any financial deal that appears to be a good deal (some net gain) must be exploiting some inefficiency in the market

Question 5

Modigliani-Miller w/ Tax

Answer 5

Interest payments are tax deductible–> creates tax shield in the form of savings equivalent to tax rate–> now incentive to lever up–> proposition 1 & 2 do not hold

Lever up to point where MC of debt = Marginal benefit from Tax shield

Question 6

Bankruptcy/Liquidation Costs (Direct)

Answer 6

Bankruptcy/Liquidation Costs:
Risky debt => positive probability of default
=> increase in D=> increase expected bankruptcy/liquidation costs increase

In event of bankruptcy ownership is transferred to creditors by way of administrative receivership
=> administrator takes control of firm assets on behalf of creditors=> may liquidate or run firm as “going concern” as options are explored (potential buyers/recapitalisation)

Question 7

Indirect Costs

Answer 7

Generally stems from conflict of interest between creditors and investors
Approx 9-15% on firm value

1. Agency problem - Investors have control=> choose board members=> only care about maxing value of equity rather than value of the total assets
   => depends on gov structure in anglo-american countries banks generally restricted from owning shares in firms=> in germany banks often own stake and sit on board.

Debt convenants can mitigate problem to some extent but bounded rationality => can’t form perfect contracts
Also negotiation and monitoring costs

Question 8

Indirect Costs - Liquidation & payment of excess dividends

Answer 8

Managers/shareholders could pay excessive dividends and then announce bankruptcy
=>Can use debt covenant to control for this
=> Regulation - UK has dividend restrictions to prevent this

Question 9

Indirect Costs - Asset Substitution

Answer 9

Equity is like a call option on the firm
=>shareholders like variance in CF=> high variance increases chance of high gains

Creditors effectively have short position on Put option
=>like selling insurance to shareholders
=>high variance = high risk of default

Shareholders have incentive to pursue high risk investments for high profits
=> essentially subbing low-risk assets for high-risk assets BUT gains from high-risk assets only accrue to shareholders, losses are shared w/ creditors

Question 10

Indirect Costs - Brand equity/Reputation

Answer 10

Bankruptcy is a signal of poor governance/management

=> could have adverse effects on industry performance, stakeholder relationships

Question 11

Indirect Costs - Contracting Costs

Answer 11

Suppliers/Complimentors may refuse to do business w/ firm due to increased business/financial risk
=>contract costs rise as firms less confidence causes contractors to add more checks and balances=> monitoring costs go up=> less leverage in negotiations leads to less favourable terms

Question 12

Indirect Costs - Debt Overhang (Myers, 1977)

Answer 12

Firm debt is such that Positive NPV projects are forgone once outstanding debt is taken into account
=> firm doesnt allocate resources efficiently
=> dynamic inefficiency=> value is less than potential
=> can use new debt to finance projects but increasing D raises claim to creditors => exacerbates debt overhang=> potential E falls=> r(d) increases, max sustainable level of D falls => Long run V falls

Also applies to countries=> creates debt spiral and erodes standard of living also applies welfare cost on future generations.

Question 13

Direct Costs

Answer 13

Approx 3.5% of firm value
1. Business disruption

2. Admin Costs
   =>Legal fees
   =>Audit fees
3. Liquidation costs
   =>Additional admin costs=> Accountants, Lawyers, Redundancy costs, Investment Bankers
   =>illiquid market for assets (particularly in case of high asset specificity) search/negotiation costs
   =>Buyers hold leverage in sales, can see distressed sellers coming

Question 14

Trade off Theory of Capital Structure (Static)

Answer 14

Kraus and Litzenberger (1973):
Optimal leverage is point that equates deadweight cost of bankruptcy with tax saving benefits of debt.
=>Equimarginal principle optimal D/E at MB=MC

Critiques of static theory:

1. Doesn’t account for the retained profit within theory
2. Doesn’t consider the dynamics of the transistion to the optimal level of leverage=> not consideration of target adjustment
3. Doesn’t explain negative correlation between profit and leverage
4. Model predicts much higher debt than empirics=> probability of bankruptcy is v. low but tax is certain so weighting on bankruptcy costs should be lower (Myers, 1984)

Question 15

Trade off Theory of Capital Structure (Dynamic)

Answer 15

Dynamic models provide an intertemporal perspective that considers the role of tax assymetries, profit, mean reversion, and path dependence on a firms financing decsions=> better address the critiques in static case, more in line with empirics

Question 16

Hennessy and Whited (2004)

Answer 16

Hennessy and Whited (2004) include personal tax, financial distress costs, and equity floatation costs=> firms not obliged to payout funds
=> found that optimal leverage is path dependent and negative correlation between profits and leverage

Question 17

Industry Capital Structure - Maio 2005

Answer 17

Observe leverage trends across industries:
1. Industry output negatively correlatied with industry D/E

2. Plant closings positively correlated with debt and negatively correlated with plant level productivity
3. Firm entry positively correlated with debt of incumbents
4. Firm investment negatively correlated with debt
5. Substantial inter and intra variance in leverage

Industries with less specific assets for example would have lower FO costs higher D*/E

Question 18

Pecking Order Theory (Myers & Maijluf, 1984)

Answer 18

Assymetric Information=> firm value is private info of management=> investors have to guess value based on managers activity=> leads to adverse selection equity market

3 Forms of financing:
1. Internal Financing=> Cash, retained earnings, marketable securities)
=>least distortionary, firms can adapt investment strategy w/o signalling to market

2. Debt=> Bond issuance/syndicated debt (assume below financial distress threshhold)
   => less costly than equity due to tax shield doesnt dilute ownership
   =>also for corporate governence reduce FCF limits inefficient use allocation of resources (Jensen, 1986)
   =>depends on tax policy and distance financial distress threshold/risk appetite of creditors)
3. Equity=> last resort, signals value of firm
   => Managers only willing to issue new shares if firm is overvalued=> rational investors know this take short position on stock=> stock falls firm value is eroded

=> Equity isuance results in selling shares at a discount=> dilutes shares of existing shareholders

Question 19

Pecking Order Theory Empirics - (Mayer, 1990)

Answer 19

72% of investment in UK financed w/ retained profit

69% of investment in US financef w/ Retained Earnings

Question 20

Pecking Order Theory Extensions - Ravid and Spiegel (1997)

Answer 20

Where there are no prior assets (e.g. for startups) firms prefer debt to equity as owners want to protect equity stake=> issues=splitting stake and influence with other investors

Relevance may be limited=> VC firms have much higher risk appetites than banks=> unlikely that startups can borrow at risk free rate if at all=>

relies on assumption that new firms can borrow at risk free rate and credit is available

Question 21

Pecking Order Theory Extensions - Eckbo and Norli (2004)

Answer 21

Allow for current shareholder involvement in equity issue and underwriter quality certification:
=> Adverse selection would be less severe if current shareholder can participate in share issue:
=>level of current shareholder participation influences equity floatation strategy
High participation = uninsured share issues
Low participation = full commitment underwritten share issue
Mid participation = standby rights issue

Question 22

Pecking Order Theory Extensions - Halov and Heider (2004)

Answer 22

Pecking Order Theory reflects a special case of adverse selection=> when asymmetric info about value

When asymmetric info is about risk=> adverse selection relates to debt and firms prefer to issue equity

Managers only raise debt when risk is underestimated so raising debt leads to increase in cost of debt drives down firm value as wacc increases

Question 23

Peking Order vs Trade Off Empirics

Answer 23

In static case:
TOT captures inter-industry variation in D/E
=> industries w/ higher % tangible assets more levered those with intangibles=> more collateral, less specific asset, easier for lenders to recoup funds in case of bankruptcy (Harris and Raviv, 1991)

POT captures intra-industry variation in D/E
=> Higher profit = less leverage=> in line w/ empirics

Dynamic Case:
TOT more robust accounts for intertemoral effect of tax assymetries, retained earnings, mean reversion, and path dependence

Question 24

Pecking Order vs Trade Off - Profits

Answer 24

Key distinction in static case:
Pecking Order implies negative correlation between profit and leverage=> more proffit means more retained earnings

Trade Off Theory implies positive correlation between profit and leverage=> more profit reduces probability of bankruptcy=> exp cost of default falls

BUT if profits seen as a proxy for growth opportunities and growth effect outweighs profitability effect=> easier for high growth firms to pursue high risk projects and harder for creditors to detect=> r(d) rises

TOT gives negative correlation in dynamic case

Question 25

POT vs TOT - Growth

Answer 25

TOT: Negative correlation between leverage and growth
=> Assest substitution is more difficult to detect for firms with high growth opportunities
=>Firms with high growth opportunies less effected by agency cost associated with FCFs, no need for debt as governance mechanism
=> growth firms lose more value when they go into financial distress=> less of a reputation to leverage

POT=> positve correlation
=> holding profits fixed more growth opportunities will require more debt-financing

Question 26

POT vs TOT - Size

Answer 26

TOT: positive correlation, D/E and firm size
=> large firms generally more mature=> have stronger reputations likely to face lower cost of debt
=>large firms more diversified, face lower default risk=> exp bankruptcy costs are lower

POT: ambiguous, D/E and firm size
=>large firms have stronger reputations, less uncertaintly around firm value=> adverse selection effect not as large so=> lower cost to issue equity
=>large firms have more stakeholders, larger group of potential shareholders could exacerbate animal spritits=> cost of issuing equity higher