Modigliani

Question 1

5 Modigliani Miller Assumptions

Answer 1

PCHNC

1. Perfect capital markets
2. Costless default
3. Homogeneous expectations
4. Tax
5. Cash flows are independent of capital structure

Question 2

MM Prop 2 Formula

Answer 2

rE = rC + D/E (rC-rD)

Question 3

Debt Overhang problem

Answer 3

Myers 1977

Firms do not want to undertake projects with positive NPVs since they will not reap reward from it, since this project is still less than the total debt of the organization. Shareholders will only accept projects with NPV greater than the face value of their debt

Question 4

Costs of financial distress

Answer 4

1.  Managers/shareholders could pay excessive dividends, then announce bankruptcy. Debtholders then write covenants (to protect assets) into debt contract
2. Asset substitution: Equity holders have call option on their firms and like variance in their cash-flows. But creditors have a short position in a put option by selling insurance to shareholders and hence dislike variance → equity holders will choose excessively risky investments (there is oppositely asymmetric payoff)
3. Debt Overhang problem (Myers, 1977)
4. More tacit cost: Suppliers and Customers want stable partnerships. May be less inclined to do business with a company, if they have a lot of debt (even if paying interest, a sudden change in profitability/FCF could mean firms cant pay interest, and might then become bankrupt)

Question 5

Miao

Answer 5

2005

• Industry output is negatively associated with the average industry debt ratio
• Firm investment is negatively associated with debt

Question 6

Wruck

Answer 6

(1990)

there can be benefits to financial distress:
o Distress can lead to comprehensive organizational changes in management, governance, and structure → create value by improving the use of resources
o Basically, firms can look at themselves and see what they’ve done wrong to improve it in the future
o True that this may not be a reason for piling on more debt (i.e. choosing to do this to get these benefits) – but still highlights that the tradeoff of value is not distinctly clear.

Question 7

Devereux and Li (2016)

Answer 7

Examine possibility of financial constraints for newly incorporated firms, 2000-2011

Use tax return data to accurately assess appropriate tax rate

For newly incorporated companies, a £10 reduction in the tax payment increases investment by around £ 7.

On average across all companies, this falls to around £ 2.

Ceteris paribus, takes around 25 years for newly incorporated companies to escape financial constraints altogether

Question 8

Myers and Maljuf

Answer 8

1984

Pecking order
Asymetric information

Question 9

Jensen

Answer 9

1986

Free cash flow theory

Due to agency costs, managers will use excess FCF to overinvest in projects that may not have a positive NPV

They want to grow more to look better and get paid more. Futhethere, they have shorter time horizons (will be gone before time horizon of project).

In this case, high debt levels will increase firm values despite distress costs because there is less cashflow for managers to play with.

Question 10

Bertrand and Schoar

Answer 10

2003

Debt vs Equity simply comes down to manager preferences.

Older CEOs are more conservative with debt, younger MBA CEOs are more agressive

Question 11

Bake and Wurgler

Answer 11

2002

Down to timing, stock prices are sometimes irrational, so raise equity when stock prices are high. (Consider recent private investment in startup boom, 2016)

Question 12

Rajan and Zingales

Answer 12

(1995)

Finds evidence of both internationally.

For TOT: larger firms tended to have higher debt ratios, since they have tangible assets (that they can sell) → less exposed to the costs of financial distress that occur when relying on risky intangible assets

For POT: more profitable firms had lower debt ratios, given that they are more able to rely on internal financing

Question 13

Structure of Essay

Answer 13

Mogdiliani Miller (Assumptions, propositions) 
Trade-off theory (main issues)
Fama and French (1998)
Myers and Maljuf (1984)
Jensen (1986)
Bertrand and Schoar (2003)
Baker and Wurgler (2002)

Empiricals
Rajan and Zingales (1995)
Lemmon et al. (2008)
Differences may be individual and idiosyncratic.

Question 14

Fama and French (1998)

Answer 14

Looking at ~5000 firms (MSCI + Compustat data) over 20 years, they find no evidence that interest tax shield contributed to firm value.

Question 15

Lemmon et al.

Answer 15

2008

Capital strucutre should be constant (or mean-reverting) over long periods of time.

Thus, profitable firms are not necessarily profitable because they have low debt, they had low debt even when they were unprofitable.