Capital Structure - Q1 Flashcards
State 5 capital Structure theories
- Modigliani and Miller’s (MM) propositions. - Capital structure with tax considerations: MM’s propositions with corporate taxes. The Miller model with both corporate and personal taxes. Non-debt tax shields.
- Financial distress costs and the trade-off theory.
- Asymmetric information and the pecking order theory.
What is Modiglian and miller proposition 1
The total value of a firm is equal to the market value of the total cash flows generated by its assets, and is NOT affected by its choice of capital structure.
Assumptions of MM’s Irrelevance propositions
Perfect capital markets without frictions: No taxes, transaction costs and issuance costs.
No agency problems and asymmetric information.
Investors and firms can borrow and lend at the same rate.
Financing decisions do not change the cash flows generated by investments.
No arbitrage
MM’s Proposition II
The cost of equity of a levered firm increases in proportion to the debt-equity ratio (D/E), expressed in market value terms.
Determinants of Capital structure
Firm size, Tangibility, Profitability, Industry capital structure, Taxes, Non-debt tax shields, Growth opportunities,
MM’s (1963) ‘corrected’ Proposition III
Firm value = All-equity Financed Value + PV(DITS)
VL = VU + Tc*D
Which Valution method should be used :
Value a project financed with all equity
Value a project financed with constant leverage
Value a project financed with a fixed level of debt
Value a project with predetermined debt repayments
WACC
WACC
APV
APV
arbitrage in MM model
The existence of an arbitrage opportunity violates the assumption of the MM model. In perfect capital markets, such an opportunity should not exist.
Adjustments will quickly eliminate any arbitrate opportunities and achieve an equilibrium.
implications of MM’s proposition 2
Misconception: increasing the amount of debt reduces the WACC because debt has a lower cost than equity.
MM showed that “any attempt to raise the value of the firm by issuing debt will be exactly offset by the increase in the cost of capital”.
MM’s propositions do not hold in the real world, what is the importance of them
The approach that MM took to derive them. If capital structure matters, it must stem from market imperfections or frictions (e.g., taxes, agency problems, asymmetric information).
MM’s ideas marked the beginning of the modern theory of corporate finance
Summary of MM’s propositions
MM’s (1958) Propositions I and II: capital structure does NOT matter.
MM’s (1963) Proposition III: capital structure is relevant with corporate taxes.
Profitable firms should use more debt. Firms with sufficient EBIT should be 100% debt financed.
These implications are extreme.
Issues to be considered: Personal taxes, Financial distress costs, Agency costs of debt.
Direct costs of Bankruptcy
Incurred to facilitate an orderly bankruptcy process (takes 2 years)
Mainly include costly professional fees (e.g., legal and accounting fees).
Average direct bankruptcy costs represent 4-17% of the pre-bankruptcy firm market value, Warner (1977)
Costs are higher for firms with more complicated operations or large number of creditors.
Relatively higher for small firms
examples of indirect costs of financial distress
Indirect costs are incurred due to the potential:
Loss of customers, loss of suppliers, loss of employees, loss of receivables, fire sales of assets, and delayed liquidation.
Overall costs for a distressed firm can be 10-23% of frim value (Andrade and Kaplan 1998) or 15-30% (Korteweg 2010)
briefly describe the lemons problem
At a price based on average quality, high-quality sellers
have little or no incentive to sell their goods
George Akerlof in 1970
Consider a financial market where firms wish to issue
new shares with Two types of firms: ‘good quality’ vs. ‘bad quality’.
explain adverse selection
The owners/managers of the securities know the true
value of the firms but the investors don’t, i.e., asymmetric
information.
Assumption: the investors believe that each security has
50% chance of being either ‘good’ or ‘bad’
However, this expected price is not an equilibrium price as ‘Bad’ firms are over-valued and ‘good’ firms are under-valued.
consequences of adverse selection
- both the quality and prices of equity issues are low
Stock market undervalues the equity of high-quality firms and
overvalues that of low-quality firms.
Investors will only be willing to pay a low price for the equity issued. High-quality firms have no incentive to issue equity, while only
low-quality firms have incentives to issue equity.
Further consequences: Underinvestment, The Pecking order of corporate financing
Pecking order theory model setup
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How does POT effect capital structure decisions
Firms prefer internal funds to external finance.
If external finance is required, firms prefer issuing “safer” claims that are least sensitive to mispricing (or undervaluation).
Pecking order of financing:
(1) internal equity or riskless debt;
(2) risky debt;
(3) debt-equity hybrids (convertibles and preferred stock);
(4) external equity (last resort).
Predictions of the POT
Firms have no well-defined optimal capital structures.
Highly-profitable firms will issue little debt, i.e., a negative relation between profitability and leverage.
Capital expenditures are mainly financed through
internally generated cash flows.
Equity is considered ‘a last resort’
Intro to Pecking order theory essay
POT is a concept in corporate finances that suggests that managers should follow a hierachy when choosing their source of financing.
First proposed by Stewart myers and Nicholas Majluf in 1984, the theory states that firms should prioritise internal financing over debt and equity with equity financing a last resort.
In POT why do we prefer internal financing
Minimising transaction costs such as underwriting spread or interest / repayment obligations
Avoiding debt covenants that may limit a companies financial flexibility ( strong survey evidence to support)
Lower risk exposure
In POT why do we prefer Debt financing
Lower cost of capital as interest is tax deductible
Avoid dilution of ownership
Market signals
Debt can be structured flexibly to align with projected cash flows
How does informational asymmetry effect POT, w.r.g equity financing
The lemons problem can be applied to equity financing. As a result of investors not having complete information about the companies true value or future prospects, they may fear that the company is overvalued or that managers are using equity issuance as a way to offload stock, this undervalues the stock
Define informational asymmetry for the POT
In the context of Pecking Order Theory (POT), informational asymmetry plays a central role in shaping a firm’s financing decisions. Informational asymmetry refers to the situation where managers have more or better information about the company’s current value, future prospects, and risks than external investors, such as creditors or shareholders. This imbalance of information affects how external financing is viewed and priced, influencing the firm’s preference for internal versus external financing.
Ties back into signalling theory
How does informational asymmetry effect POT, w.r.g debt financing
Due to asymmetry debt holders may charge a higher interest rate due to the higher perceived risk.
The reason debt is preferred over equity is that the confidence that the debt holders show in lending is a positive signal to the market of future cash flows
How to structure the POT essay
Intro
informational asymmetry
why: internal financing, debt ,equity
Overall predictions of the POT
Firms have no well-defined optimal capital structures.
Highly-profitable firms will issue little debt, i.e., a
negative relation between profitability and leverage.
Capital expenditures are mainly financed through internally generated cash flows.
If firms have a financing deficit, they issue debt to offset it, unless debt capacity is reached
If firms have a surplus they retire debt before repurchasing equity
what is the underinvestment problem
high-growth firms may reject positive NPV projects due to prohibitively high information costs of external equity
What is the universal theory of TOT vs POT
No theory Myers 2001
The trade-off theory outperforms the pecking order
theory in nested models, Flannery and Rangan, 2006
Opinions of Flannery and Rangan, 2006
The trade-off theory outperforms the pecking order
theory in nested models
UK and US firms adjust at rates of more than 50% and 30%,
respectively (showing firms adjust their leverage towards target rates)
What did Fama and French find in 2005 that went against POT
67% of sample firms issue some equity each year between 1973-1982, and the proportion rises to 74% for 1983-1992 and 86% for 1993-2002
Firms are not reluctant to issue equity
In POT what are the thoughts on issuing equity
Only as a last resort
Gives negative market signals as equity is only issued when stock is overvalued (backed up by survey evidence)
Firms mainly use debt (not equity) to offset their deficit, evidence?
Shyam-sunder and Myers 1999 Agree
mixed evidence from more recent data, Frank and Goyal 2003, who suggest small, high growth firms like to issue equity, this inconsistent with POT but could be because small companies don’t have access to debt capital (Lemmon and Zender, 2010)
POT vs TOT
Profitability
Consistent with POT, negative sign
The higher the profitability, the lower the level of leverage
If a firm is profitable, it doesn’t need to issue debt capital
POT vs TOT
Asset tangibility
Consistent with TOT, positive sign
If you have a company with tangible assets, it is very easy to issue debt as tangible assets can be collateralised.
Bankruptcy and financial distress costs are low as tangible assets have a high value
POT vs TOT
Firm Size
Consistent with TOT, positive sign
A large company usually has a lower cost of debt capital, company also is more diversified meaning the cost of financial distress is lower.
We know this because proportionally, cost of financial distress are larger for smaller companies
POT vs TOT
Industry differences
Consistent with TOT, positive sign
shows that firms within the same industry follow the capital structure of their peers, meaning they have a target leverage
POT vs TOT
Market to book (MTB)
Higher the MTB the higher the level of growth opportunities
Because when the market value is high compared to the book value it means that the market value is mainly to do with intangible assets or growth opportunities that you cannot find in the book.
high growth company should not borrow a lot, based on TOT, as they are likely to suffer a lot with financial distress
However not entirely consistent with POT becuase companies with high MTB / growth opportunities will not be able to rely on internal funds
Intro for trade of theory
The trade-off theory of capital structure suggests that firms aim for a target leverage ratio that achieves the optimal balance between the benefits of the debt interest tax shield and the costs associated with financial distress and bankruptcy, due to the level of leverage.
the theory was first suggested by Kraus and Litzenberger in 1973, building upon the foundation built by economists, Modigliani and Miller.
Survey evidence for Trade of theory
Graham (2022): 980 North American firms (CFOs)
