Capital Structure Flashcards
Modigliani-Miller (1958) Assumptions
- Perfect and Complete Capital Markets
- Homogenous Expectations
- Costless Default
- No Tax
- Cashflow independent of capital structure
Proposition 1
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
Proposition 2
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
Conservation of value principal
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
Modigliani-Miller w/ Tax
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
Bankruptcy/Liquidation Costs (Direct)
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)
Indirect Costs
Generally stems from conflict of interest between creditors and investors
Approx 9-15% on firm value
- 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
Indirect Costs - Liquidation & payment of excess dividends
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
Indirect Costs - Asset Substitution
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
Indirect Costs - Brand equity/Reputation
Bankruptcy is a signal of poor governance/management
=> could have adverse effects on industry performance, stakeholder relationships
Indirect Costs - Contracting Costs
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
Indirect Costs - Debt Overhang (Myers, 1977)
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.
Direct Costs
Approx 3.5% of firm value
1. Business disruption
- Admin Costs
=>Legal fees
=>Audit fees - 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
Trade off Theory of Capital Structure (Static)
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:
- Doesn’t account for the retained profit within theory
- Doesn’t consider the dynamics of the transistion to the optimal level of leverage=> not consideration of target adjustment
- Doesn’t explain negative correlation between profit and leverage
- 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)
Trade off Theory of Capital Structure (Dynamic)
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
Hennessy and Whited (2004)
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
Industry Capital Structure - Maio 2005
Observe leverage trends across industries:
1. Industry output negatively correlatied with industry D/E
- Plant closings positively correlated with debt and negatively correlated with plant level productivity
- Firm entry positively correlated with debt of incumbents
- Firm investment negatively correlated with debt
- Substantial inter and intra variance in leverage
Industries with less specific assets for example would have lower FO costs higher D*/E
Pecking Order Theory (Myers & Maijluf, 1984)
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
- 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) - 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
Pecking Order Theory Empirics - (Mayer, 1990)
72% of investment in UK financed w/ retained profit
69% of investment in US financef w/ Retained Earnings
Pecking Order Theory Extensions - Ravid and Spiegel (1997)
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
Pecking Order Theory Extensions - Eckbo and Norli (2004)
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
Pecking Order Theory Extensions - Halov and Heider (2004)
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
Peking Order vs Trade Off Empirics
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
Pecking Order vs Trade Off - Profits
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
POT vs TOT - Growth
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
POT vs TOT - Size
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
