"Capital structure" Myers, Stewart C

Question 1

What are the 3 major theories about debt-equity choice and what do they emphasize?

Answer 1

○ Trade-off theory: Taxes
○ Pecking order theory: Difference in information
○ Free cash flow theory: Agency costs

Question 2

What are the empirical facts about company financing?

Answer 2

● Most of the investment is financed from internal cash flow – retained earnings and depreciation (80%+)
● Net stock issues are frequently negative
● Smaller, riskier and fast growing firms rely heavily on stock issuance
● Pharma and larger growth companies have negative debt ratios (cash + marketable securities > debt)
● Industry debt ratios are low/negative when profitability and business risk are high
● Firms with high PVGO have low debt ratios

Question 3

What is the trade-off theory? What does it imply? What does it explain/not explain?

Answer 3

● Considers the trade-off of taxes from 2 perspectives:
○ Tax benefits from increased interest tax shield
○ Direct (Cost of bankruptcy/reorganization) and indirect costs (agency costs when poor credit rating) from increased debt
=> Firm will increase debt until MB=MC

● It explains why tangible assets are linked to higher debt ratios (lower financial stress)
● Does not explain why the most profitable companies borrow the least

Question 4

What is the pecking order theory? What does it imply? What does it explain/not explain?

Answer 4

● Firms prefer internal financing and debt over equity issue, due to information asymmetry between managers and investors (selling used car) => Stock price drops after announcement of equity issue

● Firms’ debt ratios reflect the cumulative need for external financing

● It explains why profitable firms borrow less (more internal financing)
● Does not explain why financing tactics are not developed to avoid the financing consequences of managers’ superior information
○ Example: Deferred equity (debt, repayable in shares); Gives no info as manager can’t know if future equity will be over/undervalued

Question 5

What is the free cash flow theory? What does it imply? What does it explain/not explain?

Answer 5

● Based on agency costs – managers tend to act in their own best interest, at the cost of shareholders

● 1 solution to reduce agency costs – increase leverage
○ Debt discipline, pressure of going bankrupt, forcing cash to go out of firm
○ Leveraged buyouts are attempts to cut back wasteful investment

● FCF is not a theory predicting how managers will choose capital structures, but a theory about the consequences of high debt ratios

● FCF together with the trade-off theory explain why managers do not fully exploit the tax advantages of borrowing

Question 6

What are the types of debt vs equity holder conflicts?

Answer 6

● Overinvestment – invest in super risky projects
● Underinvestment/debt overhang – decline +NPV projects because they benefit creditors more than shareholders
● Cashing out – take monies out before bankruptcy
● Play for time – what the name says
● Bait and switch – borrow small amount for low rate, then borrow a lot more later (1st debtholders fucked over)