GS6

Question 1

Capital structure.

What Modigliani and Miller’s theory about the capital structure they firstly proposed in 1958 was about?

Answer 1

Choice between equity and debt financing has no
material effect on the value of the firm or on the cost or availability of capital (assumed that capital markets are perfect and frictionless)

Question 2

Capital structure.

Why does the financing choice matter in the real world?

Answer 2

Taxes, difference in information, agency costs

Question 3

Capital structure.

Name 3 theories about optimal capital structure.

Answer 3

1) Trade-off theory → emphasizes taxes
2) Pecking order theory → emphasizes difference in information
3) Free cash flow theory → emphasizes agency costs

Question 4

Capital structure.

When debt ratios tend to be low or negative?

Answer 4

When profitability and business risk are high in industry.

Question 5

Capital structure.

What does the trade-off theory state?

Answer 5

The firm will borrow up to the point where the marginal value of tax shields on the additional debt is just offset by the increase in the costs of possible distress.

Question 6

Capital structure.

What does the trade-off theory cannot explain?

Answer 6

The trade-off theory cannot account for the correlation between high profitability and low debt ratios (although
profitable companies have more taxable income to shield).

Question 7

Capital structure.

What does the Pecking order theory state?

Answer 7

Firms prefer internal financing and debt to equity issue, due to information asymmetry between
managers and investors. If firms issue stock, investors believe that managers have some private information about poor future prospects → that means that equity is overvalued → stock price drops after the announcement of an equity issue.

Question 8

Capital structure.

What does the Pecking order theory cannot explain?

Answer 8

Why financing tactics are not developed to avoid the
financing consequences of managers’ superior information → one solution is to issue “deferred equity” - a debt, repayable in the firm’s shares in the future. It conveys no information because the manager cannot know whether in the future equity will be over- or undervalued.

Question 9

Capital structure.

What Free cash flow theory is about?

Answer 9

Dangerously high debt levels will increase firm value, despite the threat of financial distress (specially designed for mature firms which are prone to overinvest).
Helps the trade-off theory explain why managers do not fully exploit the tax advantages of borrowing.

Question 10

Capital structure.

Name Debt- and equity-holders conflicts (4).

Answer 10

1) Investment in riskier assets/risk-shifting/overinvestment
2) Borrow more/cash out
3) Debt overhang/underinvestment
4) “Play for time”

Question 11

Empirical capital structure: A review.

What are the determinants of the debt levels (and how they affect the amount of debt) [8]?

Answer 11

1) Tax Exposure (tax rate↑ → debt↑)
2) Cash Flow Volatility (volatility↑ → debt↓) - especially high systematic risk.
3) Size of the company (size↑ → debt ↑)
4) Asset tangibility (FA/TA ↑ → Debt↑)
5) Market to book value ratio (M/B ratio ↑ → Debt ↓) - want to maintain financial slack; overvalued equity → an incentive to use more equity financing because it is favorably priced.
6) Product Uniqueness (Uniqueness ↑ → Debt ↓) - liquidation imposes significant costs.
7) Industry Effects (Competition ↑ → Debt ↓) - don’t want to reduce flexibility
8) Firm Fixed effects (but hard to measure) - managerial preferences, governance structure, geography, competitive threats, corporate culture…

Question 12

Empirical capital structure: A review.

Why companies sometimes deviate from the target leverage ratio? [4]

Answer 12

1. Profitability (Higher profitability → less debt)
2. Market Timing (overvalued equity)
3. Stock Returns (Past stock returns ↑ → Debt ↓)
4. Managerial Preferences and Entrenchment

Question 13

Empirical capital structure: A review.

What is the effect of leverage on stakeholders of the firm?

Answer 13

1) Employees (negative: lower wages, less job security)
2) Customers (negative: lower sales because customers anticipate distress)
3) Suppliers (require lower rates of debt (protection against financial distress), especially in industries with
high R&D costs (& unique products))
4) Competitors (positive: Highly leveraged firms are forced to exit the market if the competition drives prices down during downturns, higher prices, softer competition)

Question 14

Corporate payout policy.

What does Lifecycle theory tell about payout?

Answer 14

Introduction & growth stages: company will tend to hold
cash in the company and keep payout ratio low.
Maturity stage: pay out dividends rather than waste cash on uncertain investments (lower agency costs).

Question 15

Corporate payout policy.

What are the factors stimulating payouts?

Answer 15

• investors pressure managers to accelerate cash payouts;
• managers have incentives to build a reputation for treating investors fairly in their payout decisions to be able to sell future equity at higher prices;
• firms generating large amounts of FCF are “sitting ducks” for takeovers by activist investors (if investor demand for dividends not fulfilled -> company valuation decreases).

Question 16

Corporate payout policy.

Factors retaining payouts?

Answer 16

• Agency problems – managers make decision to keep cash

- Servicing different tax clienteles

Question 17

Corporate payout policy.

What is the relationship between dividend and future earnings?

Answer 17

Firms that increase dividends are less likely to experience a decline in future earnings than firms that do not increase them. Explanation: Managers are reluctant to increase dividends when the chances are good that they will later be forced to reverse that decision.

Question 18

Corporate payout policy.

What can be the reasons for the reduction in dividends?

Answer 18

Managers use dividend cuts strategically to “plead poverty” and thereby to help convince outsiders who do not share managers’ inside information either to provide financial relief to, or to forego certain claims against the firm.

Question 19

Corporate payout policy.

What are investor’s behavioural biases that can influence payout policy?

Answer 19

• “consume only out of dividends”–require higher dividends for current consumption
• “regret aversion”– rather consume dividends than sell shares and regret about it when price increases
• “mental accounting”- Investors value income coming from different sources differently (dividends might be “more valuable” than capital gains)
• Catering theory - “investor sentiment” for dividends varies over time à firms are predicted to supply more dividends in some periods, and less in others, depending on the sentiment premium or discount that investors assign to dividends in those particular periods

Question 20

Corporate payout policy.

What are the reasons for high dividends?

Answer 20

1. Lower agency costs
2. Low growth companies
3. Signaling theory
4. Bird in hand theory (if investments are highly uncertain)
5. Clientele effect (taxes)
6. Trading costs (costly to replicate dividends payouts)

Question 21

Corporate payout policy.

What are the reasons for low dividends?

Answer 21

1. Costs of financial distress (rather sit on cash than deal with costs of financial distress)
2. Good growth prospects
3. Personal taxes of shareholders
4. Clientele effect (trying to attract tax-conscious) investors

Question 22

Corporate payout policy.

What are the advantages of stock repurchase? [7]

Answer 22

1. Financial flexibility
2. Correct stock market valuation (Repurchase stock when firm’s shares are undervalued)
3. Remove low valuation stockholders (avoid takeover)
4. Allocation of voting rights
5. Increase reported EPS (lower nosh and actual improvement in operations)
6. Save transaction costs (reduce investor
   relations expenditures)
7. Provide liquidity to investors who want to sell shares

Question 23

Overvalued equity and financing decisions.

Why should companies raise more capital when overvalued?

Answer 23

1) Catering investors’ expectations (raising capital to finance ambitious projects is especially strong among overvalued firms)
2) Low costs
3) Project scale economies
4) Investor short-termism

Question 24

Overvalued equity and financing decisions.

What was used as a misvaluation proxy?

Answer 24

V/P = “intrinsic value” (V ) / market price (P).
V/P is a misvaluation proxy and a strong predictor
of future abnormal returns. (Intrinsic value reflects not only current book value but also a discounted value of analyst forecasts of future earnings).
In contrast to the B/P ratio, V/P is not correlated with firm characteristics other than misvaluation, such as risk, growth opportunities, managerial discipline and the degree of information asymmetry.

Question 25

Overvalued equity and financing decisions.

Main findings?

Answer 25

1) Total issuance and equity issuance is significantly positively related to overvaluation.
2) Equity issuance is more positively sensitive to overvaluation than debt issuance.
3) Sensitivity of equity issuance and total issuance to misvaluation is strongest among overvalued
firms.
4) Growth firms (low B/M or high R&D), firms with less tangible assets and high R&D, and small firms have much stronger overvaluation effect on equity issuance and total issuance.
5) Firms with high share turnover have a higher sensitivity to mispricing (as a proxy for short-termism
of shareholders)– such shareholders want issue shares for the purpose of financing the ambitious and expensive projects that can bring quick profits).

Question 26

Fiduciary duties and equity-debtholder conflicts.

Why Delaware court’s ruling was so important?

Answer 26

1991 Credit Lyonnais v. Pathe Communications → when a firm is not insolvent, but in the “zone of insolvency”, duties are already owed to creditors → when a company is in serious trouble, the director’s responsibilities shift somewhat in the direction of the creditors.

Question 27

Fiduciary duties and equity-debtholder conflicts.
What are debt-equity conflicts (in situations close to
bankruptcy)?

Answer 27

1. The debt overhang problem (underinvestment)
2. The risk-shifting problem (equity-holders have an incentive to increase the riskiness of the firm’s existing assets)
3. High interest rates and restrictive covenants.

Question 28

Fiduciary duties and equity-debtholder conflicts.

What was the impact of the new ruling?

Answer 28

1) Investment
• investment is higher for firms incorporated in
Delaware, compared to firms incorporated elsewhere → new policy reduces debt overhang problem
2) Equity issues and payout
• Firms relatively close to financial distress become
more likely to issue equity → new policy reduce debt
overhang problem
• No significant effect on payout policy
3) Risk and volatility
• Operational and financial risk decreased
• decrease in ROA volatility after the ruling for firms closer to distress is consistent with a reduction in risk-shifting incentives
4) Capital structure
• Leverage increased since agency costs are lower
5) Debt covenants
• A reduction in covenant use
6) Valuation
• Higher firm value (from increased tax shields)

Question 29

Leveraged buyouts and private equity.

Describe a business model of Private Equity Firms.

Answer 29

PE firms raise equity capital through a PE fund.
PE funds organized as limited partnerships → general
partners (PE firm) manage the fund, limited partners
(institutional investors and wealthy individuals) provide
most of the capital.
PE funds have a fixed life (10 years, which can be
extended for up to 3 additional years).
The private equity firm typically has up to five years to
invest the capital committed to the fund into companies, and then has an additional 5 -8 years to return the capital to its investors.

Question 30

Leveraged buyouts and private equity.

How are PE firms (general partner) compensated?

Answer 30

1) Annual management fee (% of capital committed and employed)
2) A share of the fund’s profits (”carried interest”) (around 20%)
3) Deal and monitoring fees charged to the companies in which investment was made

Question 31

Leveraged buyouts and private equity.

How do LBOs influence companies?

Answer 31

1. Financial engineering (lever up - the value of firm up)
2. Governance engineering (the management team receives a large equity upside through stock and
   options → they have higher incentive to increase the value of the firm; PE investors control the boards of companies, are actively involved in governance; replace poorly performing management)
3. Operational engineering (Use industry and operating knowledge to identify attractive investments, to develop value creation plans for those investments, and to implement the value creation plans;
   Cost-cutting and productivity improvements, strategic changes or repositioning, acquisition opportunities )

Question 32

Leveraged buyouts and private equity.

Why PE industry is highly cyclical?

Answer 32

• Cost of debt < cost of equity → PE can benefit
from the difference
• Borrow at low cost to perform LBO - more liberal
repayment schedules and looser debt covenants