Guiding Seminar 6 (2020)

Question 1

Capital Structure
Myers, Stewart, 2001

Describe Modigliani & Miller theory

Answer 1

If we live in perfect capital markets, the choice between EQUITY AND DEBT financing is IRRELEVANT- no material effect on the value of the firm or on the cost or availability of capital.

In the real world, the financing choice does matter because of taxes, difference in information, agency costs

Question 2

Capital Structure
Myers, Stewart, 2001

Name 3 theories that explain why capital structure matters

Answer 2

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

Question 3

Capital Structure
Myers, Stewart, 2001

How are companies financing themselves nowadays?

Answer 3

Most of the investment is financed from INTERNAL CASH FLOW (depreciation and retained earnings)

External financing is usually less than 20% of real investment, mostly consists of debt

Question 4

Capital Structure
Myers, Stewart, 2001

Describe the situation with stock issuance

Answer 4

Net STOCK ISSUES are frequently NEGATIVE:

• shares are eliminated in acquisitions
• shares are repurchased rather than issued

Only smaller, riskier and more rapidly growing firms rely heavily on stock issuance.

Question 5

Capital Structure
Myers, Stewart, 2001

Describe the situation with debt in companies

Answer 5

Industry debt ratios are low or negative when profitability and business risk are high (like now).

Pharmaceutical and many prominent growth companies typically operate at negative debt ratios (cash and marketable securities > debt) - probably because a lot of R&D is going on and you need cash.

Firms with valuable growth opportunities tend to have low debt ratios

Question 6

Capital Structure
Myers, Stewart, 2001

Describe tradeoff - theory

Answer 6

Increased leverage is good because you get tax shields, bad because of possible default costs.

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.

(marginal benefit of tax shields = marginal costs of financial distress)

Question 7

Capital Structure
Myers, Stewart, 2001

What are costs of financial distress?

Answer 7

1) Direct = the costs of bankruptcy or reorganization

2) Indirect = the agency costs that arise when the firm’s creditworthiness is in doubt

Question 8

Capital Structure
Myers, Stewart, 2001

What doesn’t the trade-off theory account for?

Answer 8

The most profitable companies tend to borrow the least (although they have more taxable income to shield)

The trade-off theory cannot account for the correlation between high profitability and low debt ratios.

Question 9

Capital Structure
Myers, Stewart, 2001

Explain Pecking order theory

Answer 9

Firms will firstly finance themselves from internal financing (retained earnings), then debt, then equity.
This is because of 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.
Also, debt suffers from adverse selection much less than equity, thus, will be issued first.

Question 10

Capital Structure
Myers, Stewart, 2001

What do firm’s debt ratios reflect?

Answer 10

Firms’ debt ratios reflect the cumulative need for external financing - if firms issue equity, they are really reallly in need of it.

Question 11

Capital Structure
Myers, Stewart, 2001

What doesn’t Pecking Order theory explain?

Answer 11

Why financing tactics are not developed to avoid the
financing consequences of managers’ superior information, e.g. use “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 12

Capital Structure
Myers, Stewart, 2001

Describe Free Cash Flow Theory

Answer 12

FCF says that dangerously high debt levels will increase firm value, despite the threat of financial distress
(especially designed for mature firms which are prone to overinvest)

FCF is not really a theory predicting how managers will choose capital structures, but a theory about the
consequences of high debt ratios. Helps the trade-off theory explain why managers do not fully exploit
the tax advantages of borrowing.

The theory is based on agency costs. To avoid them, one could increase leverage, which would:
• Discipline managers and strengthen their incentives to maximize value to investors (e.g. covenants that restrict taking too large risks)
• Forces them to generate cash (to repay debt)
• Leveraged buyouts (LBOs) - in the first place considered to be attempts to cut back wasteful
investment and discipline the management

Question 13

Capital Structure
Myers, Stewart, 2001

How do managers transfer the risk of default from creditors to debtors? (act in the interests of shareholders, not debtholders)

How do debtholders deal with this?

Answer 13

1) Investment in riskier assets/risk-shifting/overinvestment → increase the “upside” for stockholders, the “downside” is absorbed by the firm’s creditors (think long call)
2) Borrow more/cash out → pay out cash to stockholders
3) Debt overhang/underinvestment → cut back potential investments (even ones that would increase the overall value of the firm), because cash flows to creditors would be relatively bigger than to equity holders. Creditors would benefit more.
4) “Play for time” → managers conceal problems to prevent creditors from acting to force
immediate bankruptcy (link to options’ logic)

Debt investors (creditors) try to avoid this 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.

Question 14

Corporate payout policy
DeAngelo, DeAngelo, Skinner (2008)

Explain the dividend payout theory - lifecycle theory

Answer 14

1. Introduction & growth stages:
   Company has a lot of profitable investment
   opportunities – requires cash, thus, they will PAYOUT LESS and keep cash in the company
2. Maturity stage:
   Fewer or no investment opportunities with NPV>0,
   but earnings grow → PAYOUT MORE dividends rather
   than waste cash on uncertain investments

Also, agency costs require higher dividends as a
disciplinary measure to prevent wasteful
investment

Question 15

Corporate payout policy
DeAngelo, DeAngelo, Skinner (2008)

Describe 3 factors that stimulate payouts

Answer 15

1. INVESTORS PRESSURE managers to accelerate cash payouts (avoid wasteful investment & managers’ personal benefits)
2. 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
3. Firms generating large amounts of cash and not paying it out are “SITTING DUCKS” for TAKEOVERS by activist investors (if investor demand for dividends not fulfilled -> company valuation decreases).

Question 16

Corporate payout policy
DeAngelo, DeAngelo, Skinner (2008)

Describe 2 factors that lower the payout ratio

Answer 16

1. AGENCY problems – managers make the decision to keep cash (personal gains, overconfidence, all the behavioral things)
2. Servicing different tax clienteles: some investors face HIGH TAX RATE on dividends and they prefer deferred payouts. Firms with such investors specialize in retention (if my shareholders need to pay high taxes on dividends, their wealth is reduced and I will pay out less, let them realize profit on capital gains)

Question 17

Corporate payout policy
DeAngelo, DeAngelo, Skinner (2008)

Explain the signaling effect of dividends

Answer 17

Share prices increase when the dividend payout ratio is increased -> shareholders think that managers know more about the firm, and if a firm increases dividens payments, they must be doing really good, future earnings look amazing.

This is true, because of the “stickiness” of dividends - lowering them will have a huge bad impact on share price, as it signals that the company is doing bad. Thus, managers would not increase dividends if there was a chance that they will later be forced to reverse decision (decrease them again)

Question 18

Corporate payout policy
DeAngelo, DeAngelo, Skinner (2008)

Explain the signaling effect of dividends: empirical evidence

Answer 18

Empirical evidence: dividend changes are not useful in predicting future earnings changes (it is not certain that when you increase dividends, your future earnings will grow as well)
Changes in dividends tell us mostly about what has happened, not what will.

DIVIDEND CHANGES - BAD PREDICTOR FOR FUTURE EARNINGS (empirically)

Question 19

Corporate payout policy
DeAngelo, DeAngelo, Skinner (2008)

What is the dividend reduction associated with? What could be another (ill) reason to reduce dividends?

Answer 19

Dividend reductions are typically associated with large share price declines, but it does not indicate that
managers deliberately use dividend cuts to signal bad news to investors.

Another reason for reduction is: 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 (I whine to you that I cannot pay for bulochka, so you allow me to not pay for bulochka)

Question 20

Corporate payout policy
DeAngelo, DeAngelo, Skinner (2008)

Explain 4 investors behavioral biases towards dividends

Answer 20

1. “consume only out of dividends”– require higher dividends for CURRENT CONSUMPTION (I want money NOW)
2. “regret aversion”– rather consume dividends than sell shares and REGRET about it when PRICE INCREASES (I will be sad if I sell my apartment for less than I could have, but if someone pays me rent to hold this apartment, I am happy)
3. “mental accounting”- Investors value income coming from different sources differently (dividends might be “more valuable” than capital gains) (dividends perceived as a GIFT)
4. Catering theory - “investor SENTIMENT” for dividends VARIES over time. Thus, firms are predicted to pay more dividends in some periods, and less in others, depending on the sentiment that investors assign to dividends in those particular periods (sometimes I want regular cash, sometimes I want to sell stuff)

Question 21

Corporate payout policy
DeAngelo, DeAngelo, Skinner (2008)

Explain managers behavioral bias in paying out dividends

Answer 21

Investors demand that mature firms make substantial payouts to prevent managers from holding cash –
managerial overconfidence can lead to higher spending of free cash.

INVESTORS DO NOT WANT YOU TO HOLD CASH, SO YOU DON’T PAYOUT, BUT SPEND IT ON DUMB PROJECT, BECAUSE YOU ARE SURE THAT IT WILL WORK OUT (although it probably will not)

Question 22

Corporate payout policy
DeAngelo, DeAngelo, Skinner (2008)

What is clientele theory? Is it true?

Answer 22

Because stockholders have different desires for current dividends versus capital gains, firms will tailor their payout policies accordingly.

However, it is DOUBTFUL that a given firm could really improve its value by selecting a payout policy that appeals to a specific investor clientele.

Question 23

Corporate payout policy
DeAngelo, DeAngelo, Skinner (2008)

What are the legitimate reasons that investors prefer dividends or capital gains

Answer 23

1. investors’ personal TAX minimization – firms that retain dividends will please investors who face higher taxes on dividends
   2) TRANSACTION COSTS from arranging a personally optimal time pattern of consumption
   3) GOVERNMENT REGULATION (e.g., “prudent man” guidelines that encourage institutional investors to own dividend-paying securities)

Question 24

Corporate payout policy
DeAngelo, DeAngelo, Skinner (2008)

Describe 6 reasons for high dividends

Answer 24

1. LOWER AGENCY COSTS → fewer opportunities for wasteful investment
2. LOW GROWTH companies → mature companies with a lack of good investment prospects (only zero/negative NPV projects are available)
3. SIGNALING theory → dividends signal firm’s future performance (try not to cut dividends to avoid a decrease in share prices because of information asymmetry)
4. Bird in hand theory → if investments are highly uncertain, shareholders will prefer the money to be paid out as dividend than invested (desire for current income) (I want MONEY NOW)
5. CLIENTELE effect → ATTRACT INVESTORS who are interested in high dividends payouts (ex. companies facing low taxes)
6. TRADING COSTS → costly to replicate dividends payouts (i.e “homemade” dividends)

Question 25

Corporate payout policy
DeAngelo, DeAngelo, Skinner (2008)

Describe 4 reasons for low dividends

Answer 25

1. Costs of FINANCIAL DISTRESS (rather sit on cash than deal with costs of financial distress due to defaulting on debts – especially for highly leveraged companies)
2. Good GROWTH PROSPECTS → positive NPV investment opportunities → typically for younger firms
3. Personal TAXES of shareholders → use repurchases trying to minimize taxes for shareholders
4. CLIENTELE effect → trying to ATTRACT tax-conscious INVESTORS

Question 26

Corporate payout policy
DeAngelo, DeAngelo, Skinner (2008)

Describe 6 advantages of stock repurchases

Answer 26

1. FINANCIAL FLEXIBILITY
   - Allows you to repurchase stock whenever you want, you do not have to keep distributing the same (or more) amount of cash all the time.
   - Allows to reduce level and frequency of payouts
2. CORRECT STOCK MARKET VALUATION
   Repurchase stock when firm’s shares are undervalued (don’t give equity away “cheaply”)
3. REMOVE LOW VALUATION STOCKHOLDERS
   - Avoid a takeover - low valuation stockholders will want to sell their shares cheaply
   - A means of increasing the value of the managers’ personal stake
4. ALLOCATION ON VOTING RIGHTS
   - remove a threatening large block stockholder
   - increase managers’ percentage ownership of voting rights
5. INCREASE REPORTED EPS
   - Mechanical increases in EPS simply due to fewer shares
   - Actual improvement in operating performance after stock repurchases
6. SAVE TRANSACTION COSTS
   - After reducing the number of shareholders, the firm is able to reduce its investor relations expenditures (e.g. the costs of annual report mailings, responding to inquiries about company performance, etc.)
   (only for small firms)
7. PROVIDE LIQUIDITY TO INVESTORS WHO WANT TO SELL SHARES

Question 27

“Fiduciary duties and equity-debtholder conflicts” (Becker, Bo, and Per S., 2012)

What is the difference between fiduciary duties for solvent and insolvent firms? What rule was established in 1991 regarding this topic?

Answer 27

In solvent firms, fiduciary duties are owed to:

• —the firm as a whole;
• —firm’s owners,
• —NOT to other firm stakeholders (such as creditors)

In insolvent firms, fiduciary duties are owed to:
—-all interested parties (including creditors)

1991 Delaware Rule:
If 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 should shift somewhat in the direction of the creditors.”

Question 28

“Fiduciary duties and equity-debtholder conflicts” (Becker, Bo, and Per S., 2012)

What are the most common debtholder and equity holder conflicts if a firm is on a verge of bankruptcy?

Answer 28

1) The DEBT OVERHANG (“debt burden so large that an entity cannot take on additional debt to finance future projects”) problem:
- –equity-holders have low incentives to invest into projects even with positive NPV, which can make debt safer → underinvestment
- –dholders WIN (debt becomes less risky);
- –eholders LOSE (no benefits from investment growth)

2. The RISK-SHIFTING problem:
   - –equity-holders have an incentive to increase the riskiness of the firm’s existing assets (nothing to lose → “gamble” trying to raise the chance of getting extra return)
   - dholders LOSE;
   - eholders WIN
3. High interest rates and restrictive covenants:
   —a way for creditors to protect themselves from
   the two problems described above even before bankruptcy problems arise
   —dholders WIN;
   eholders LOSE

Question 29

“Fiduciary duties and equity-debtholder conflicts” (Becker, Bo, and Per S., 2012)

How have investments, equity issues, risk, capital structure, valuation and use of debt covenants been impacted since the Delaware rule?

Answer 29

1) Investment
- –investments in Del.>investments 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 reduces debt overhang problem

3) Risk and volatility
- –operational and financial risk decreased after the ruling for firms closer to distress
- –reduction in risk-shifting incentives

4) Capital structure
- –increased leverage

5) Debt covenants
- –reduction in covenant use

6) Valuation
- –higher firm value (from increased tax shields)