Guiding seminar 6 (2020) Flashcards
Is the US public corporation in
trouble?
What are the author’s findings of listed firms in the US?
The number of listed firms increases rather steadily until 1997. After that, the number falls rapidly until 2003 and then continues to fall at a slower pace, before leveling out around 2013 -> “listing gap” - fewer listed firms than expected
• Reason: both low numbers of newly listed firms and high numbers of delists
Is the US public corporation in
trouble?
What are the three main reasons for a public firm to delist?
The three main reasons for a public firm to delist are:
1) it no longer meets the listing requirements, which is typically due to financial distress
2) it has been acquired
3) it voluntarily delists.
Is the US public corporation in
trouble?
What are the two ways to measure the age of the firm?
Two ways to measure the age of a firm:
1) from the date of incorporation (lacking in databases)
2) from the date the firm went public (downward biased)
• Aging trend is more dramatic among public firms than private firms
• Loderer, Stulz, and Walchli (forthcoming) find that older firms innovate less and are more
rigid.
Is the US public corporation in
trouble?
What is the main concern with fewer bur larger firms?
Concern with fewer but larger firms is that concentration within industries can increase, which could possibly adversely affect competition (difficult to enter the market for small firms).
• Herfindahl Index: industries are on average much more concentrated now than 20 years ago, but less
than 40 years ago
Is the US public corporation in
trouble?
What are the main findings by the authors?
- Fewer but larger firms today
- Concentration within industries can increase (which could possibly adversely affect competition –> difficult to enter the market for small firms)
- Increase in the importance of intangible assets (high R&D (research and development) expenditures).
- Decrease in capital investment
- Inventory holdings fall (just-in-time production process)
- Firms hold more cash (the increase in R&D)
- With the growing investment in intangible assets, a firm’s balance sheet becomes a less informative measure of the firm’s financial position.
- Larger firms have a higher ratio of cash flows to assets (firms have been performing poorly on average, except for large firms)
Is the US public corporation in
trouble?
What is the possible disadvantage of the growing investment of intangible assets?
With the growing investment in intangible assets, a firm’s balance sheet becomes a less informative measure of the firm’s financial position (investment in intangible assets not recorded in the balance sheet).
Is the US public corporation in
trouble?
What are the reasons why on average firms’ cash flow to assets ratio has fallen sharply? (i.e. not the case for large firms)
• Poor performance can be found in the fact that the fraction of firms with negative net income increases over time (increase in cash holdings noted in the previous section is partly due to firms raising cash to fund losses)
• A substantial proportion of the decline in average operating cash flow is related to the rise of research and development spending - R&D is expensed -> using “adjusted operating cash flow” decline is less pronounced
• Over the last 40 years, there has been a dramatic increase in the concentration of the
profits and assets of US firms - top 30 firms earn 50% of the total earnings of the US
public firms
Is the US public corporation in trouble?
In which way are fixed assets more valuable than R&D for a company?
Fixed assets provide collateral against which firms can borrow, but research and development is difficult to
finance with debt, as R&D in process cannot be seized by creditors if a firm gets in trouble and its value is
hard to ascertain.
Is the US public corporation in trouble?
To what does the increase in R&D spending lead to?
More R&D (intangible assets) –> less leverage for the firm since only fixed assets can serve as a collateral
Consequently, an increase in R&D should lead to a decrease in firm leverage -> evidence is that:
1) leverage falls dramatically for an equally weighted measure of leverage
2) asset weighted book leverage ratio rises, before dropping sharply after the financial crisis
3) “net leverage ratio” (debt minus cash over total assets) - falls steadily and is positive in only two years,
2008 and 2015
Moreover, percentage of listed firms without debt increases fairly steadily.
In addition to debt, firms issue equity to finance themselves. Smaller firms issue equity and larger firms
repurchase more shares than they issue.
Is the US public corporation in trouble?
What do the authors find about the ownership of firms?
- Institutional ownership of common stock is much higher now. Institutions tend to prefer large firms, so institutional ownership is higher for the asset-weighted average than for the equally weighted average.
- It is now much more common for a firm to have an institutional investor who controls 10 percent or more of the shares. The percentage of US firms with a 10 percent institutional shareholder increases more than twice in the past 40 years.
Is the US public corporation in trouble?
What are the payout policies for shareholders of public
firms?
• Profitable firms can use their cash flows to pay dividends, buy back shares, increase their cash holdings, or invest
• Agency problem of free cash flow (payout rates are too low): managers of public firms often retain earnings even when they cannot reinvest them profitably, which destroys shareholder wealth
• The payout rate, defined as dividends plus repurchases as a fraction of net income, is at
an all-time high in 2015 (inconsistent with worsening of agency problems, but it is consistent with a perceived lack of investment opportunities or with reduced incentives of firms to invest)
• Dividend payments as a percentage of assets follows a U-shape pattern during the sample period
• Over the past 40 years, share repurchases increase considerably -> stock repurchases are at record levels in the 2000s and extremely high in recent years
Is the US public corporation in trouble?
Reallocation of resources naturally leads to consolidation, with less-efficient firms being acquired by more-efficient firms. BUT (!): If
consolidation has nothing to do with being a public firm, we should see the total number of firms decreasing, which is not the case.
Is the US public corporation in trouble?
What is the possible explanation why the number of listed firms has decreased?
Possible explanation: regulatory burden
associated with being public increased (only part of the explanation, as drop starts before regulatory changes and more firms are delisted because of merger than went private)
Result: fewer public firms because a) it has become harder to succeed as a public corporation and b) benefits of being public have fallen;
Is the US public corporation in trouble?
Why has the fraction of small PUBLIC firms has decreased dramatically?
1) firms don’t want to disclose their project to large audience and might-be competitors, the process that is generally required to attract equity investors.
2) public markets have become dominated by institutional investors (small firms don’t have enough scale for their investment and receive less attention)
3) developments in financial intermediation and regulatory changes have made it easier to raise funds as a private firm
4) economies of scope hypothesis: small firms have become less profitable and less able to grow on a stand-alone basis -> better off selling themselves to a large organization that can bring a product to market faster and realize economies of scope
5) increased concentration could also make it harder for small firms to succeed on their own
6) increased importance of intellectual property makes it difficult for small firms to grow without acquiring patents
7) it has become easier to put a new product on the market without hard assets (ex, Netflix)
Is the US public corporation in trouble?’
Why are the concentration and the decreasing number of small public firms bad for the economy?
Larger firms may be able to worry less about competition, and do not have to innovate and invest -> less investment, less growth, and less
dynamism
Capital structure
What do Modigliani and Miller say about the debt-equity choice for firms? What are the three theories related to it?
Modigliani and Miller (1958) → 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)
In the real world, the financing choice does matter → taxes, differences in information, agency costs.
Three theories related to that:
• Trade-off theory → emphasizes taxes
• Pecking order theory → emphasizes differences in information
• Free cash flow theory → emphasizes agency costs
Capital structure
What are some of the facts the authors found about the financing?
- Most of the aggregate gross investment is financed from internal cash flow (depreciation and retained earnings)
- External financing in most years covers less than 20% of real investment and mostly consists of debt
- Net stock issues are frequently negative - more shares are extinguished in acquisitions and share repurchase programs that are created by new stock issues
- Smaller, riskier and more rapidly growing firms rely heavily on stock issuance
- Pharmaceutical and many prominent growth companies → typically operate at negative debt ratios (cash and marketable securities > outstanding debt)
- In general, industry debt ratios are low or negative when profitability and business risk are high
- Firms with valuable growth opportunities tend to have low debt ratios
Capital structure
What is the trade-off theory?
A taxpaying firm that pays extra dollar interest, receives “interest tax shield” in the form of lower taxes paid. Financing with debt instead of equity increases the total after-tax dollar return to debt and equity investors and should increase firm value.
Trade-off theory deals with tax benefits of debt on the one side and increased costs of financial distress
on the other side.
It says that 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.
Costs of financial distress:
• Direct → the costs of bankruptcy or reorganization
• Indirect → the agency costs that arise when the firm’s creditworthiness is in doubt
According to the theory, a value-maximizing firm should never pass up interest tax shield when the cost
of the financial distress is low. However, the most profitable companies tend to borrow the least.
Capital structure
What are the two types of costs of financial distress?
Costs of financial distress:
• Direct → the costs of bankruptcy or reorganization
• Indirect → the agency costs that arise when the firm’s creditworthiness is in doubt
Capital structure
What is the pecking order theory?
Pecking order theory
1. 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.
2. Dividends are “sticky” - if in need of cash, firms use external financing rather than cut dividends
3. If external funds are required, firms will issue the safest security first → debt before equity (debt suffers from adverse selection much less than equity)
4. Firms’ debt ratios reflect the cumulative need for external financing
This theory explains why profitable firms borrow less - because such firms have more internal financing available.
However, the theory does not explain why financing tactics are not developed to avoid the financing consequences of managers’ superior information → one solution is to issue “deferred equity” → such issue conveys no information because the manager cannot know whether in the future equity will be over- or undervalued
Capital structure
What does and does not explain the pecking order theory?
This theory explains why profitable firms borrow less - because such firms have more internal financing available.
However, the theory does not explain why financing tactics are not developed to avoid the financing consequences of managers’ superior information → one solution is to issue “deferred equity” → such issue conveys no information because the manager cannot know whether in the future equity will be over- or undervalued
Capital structure
What is the free cash flow theory?
Free cash flow theory- FCF is not really a theory predicting how managers will choose capital structures, but a theory about the consequences of high debt ratios
Built on the agency costs – conflict between managers and stockholders, when managers tend to act in
their own interest. For example:
• Empire building (managers want to run a large business)
• Private benefits of control
• Entrenching investment
• “Pet projects”
• Managerial overconfidence
One possible solution – increase leverage:
• disciplines managers and strengthens their incentives to maximize value to investors
• forces them to generate and pay out cash
• Leveraged buyouts (LBOs) → in the first place considered to be as attempts to cut back wasteful
investment and discipline the management
• Reason why the managers of established companies do not voluntarily move to dangerous debt
ratios
• Helps the trade-off theory explain why managers do not fully exploit the tax advantages of borrowing
Capital structure
Why don’t managers of established companies fully exploit the tax advantages of borrowing?
Explanations: Free cash flow theory and trade-off theory
Trade-off theory: take more debt until PV(tax shield) = PV(agency plus expected default costs) –> trade-off between the benefits and costs of debt
FCF theory- more leverage disciplines managers and reduces some agency costs
Capital structure
What are the four debt- and equity-holders conflicts?
If managers act in the interests of stockholders, then when facing the risk of default, they will tend to transfer value from creditors to debtors. Ways to do it:
1. Investment in riskier assets/risk-shifting/overinvestment → increase the “upside” for stockholders, the “downside” is absorbed by the firm’s creditors
2. Borrow more/cash out → pay out cash to stockholders
3. Debt overhang/underinvestment → cut back equity-financed capital investment (the greater the risk of default, the greater the benefit to existing debt from
additional investment)
4. “Play for time” → managers conceal problems to prevent creditors from acting to force immediate bankruptcy
• Debt investors (creditors) are aware of the conflicts and try to avoid them by writing contracts properly → debt covenants restrict additional borrowing, limit dividend payouts and other distributions to stockholders, and provide that debt is immediately due and payable if other covenants are seriously violated
Capital structure
How can debt holders avoid the conflicts in case of default?
Debt investors (creditors) are aware of the conflicts and try to avoid them by writing contracts properly → debt covenants restrict additional borrowing, limit dividend payouts and other distributions to stockholders, and provide that debt is immediately due and payable if other covenants are seriously violated
Empirical capital structure: a review
What are the determinants of target leverage?
- Tax Exposure (tax rate↑ → debt↑)
Interest Tax Shield = Corporate Tax Rate * Interest Payments
• debt becomes less popular after the reduction in tax rates
• firms with high marginal tax rates issue more debt than the ones with lower taxexposure. - Cash Flow Volatility (volatility↑ → debt↓)
• Traditional and intuitive argument: high volatility -> high probability of bankruptcy -> should use lessdebt
• Bankruptcy is more likely to occur during bad times -> firms with higher systematic risk will have lower debt ratios - Size of the company (size↑ → debt ↑)
• Fixed costs of refinancing are higher for smaller 12firms
• No “pure” size effect - firm size is correlated with a number of omitted factors that influence borrowing costs (ex., larger firms are more diversified, have lower volatility and higher cash flows) -> lower probability of bankruptcy → allows larger firms to take on more debt
• Large firms → easier to raise cash by selling assets in case ofdistress
• Large firms → banks are more willing to provide credit (better reputation), better access to debtmarkets - Asset tangibility (FA/TA ↑ → Debt↑)
• most common rationale: tangible assets better preserve their value during default, and as such, increase the recovery rates of creditors
• related idea: in case of default, the costs of redeploying tangible assets is lower than for intangibleassets
• Intangible assets have subjective and different value for all the potential bidders - Market to book value ratio (M/B ratio ↑ → Debt ↓)
• Firms with high M/B ratio → good future prospects/growth opportunities → use internal
financing to fund those growth opportunities
• Firms with high M/B ratio → overvalued equity → an incentive to use more equity financing because it is favorably priced - Product Uniqueness (Uniqueness ↑ → Debt ↓)
• Firm’s nonfinancial stakeholders are more likely to be concerned about the financial health of more unique firms as liquidation imposes significant costs on its workers, customers, and suppliers -> don’t want the firms to take on a lot of debt - Industry Effects (Competition ↑ → Debt ↓)
• Debt reduces the flexibility of operations (constant payouts required) -> firms operating
in competitive industries prefer to keep low debt ratios - Firm Fixed effects
• Number of factors such as managerial preferences, governance structure, geography, competitive threats, corporate culture, and so on, can affect debt ratios, but it is hard to measure them
