Package 6 Flashcards
CAPITAL STRUCTURE
3 theories of Debt-Equity Choices
Trade off
Pecking order
FCF
CAPITAL STRUCTURE
Modigliani and Miller Proposition
Financing doesn’t matter (in perfect financial
markets!) -> in real world financing structure does matter
CAPITAL STRUCTURE
Two types of Costs of financial distress and bankruptcy
a) Direct (liquidation & reorganization costs)
b) Indirect (agency costs: debt overhang, risk shifting, playing for
time, cashing out)
CAPITAL STRUCTURE
four types of Debt vs equity-holder conflicts
1) Investment in riskier assets
- increases upside for shareholders, downside is born by creditors
2) Borrow more
- use borrowed money to pay to shareholders
3) Debt overhang
- cut back capex, because the value goes to debt-holders
4) “Play for time”
- postpone announcement of bankruptcy
CAPITAL STRUCTURE
The sense of Capital Structure
The study of capital structure tries to explain the mix of securities and financing sources used by corporations to finance real investment (This study analyzes particularly U.S corporations).
CAPITAL STRUCTURE
Explain The tradeoff theory
o The tradeoff theory- firms seek debt levels that balance the tax advantages of additional debt against the costs of possible financial distress.
CAPITAL STRUCTURE
Explain The pecking order theory
o The pecking order theory- firm will borrow, rather than issue equity, when internal cash flow is not sufficient to fund capital expenditure.
CAPITAL STRUCTURE
Explain Free cash-flow theory
o The free cash flow theory- dangerously high level of debt will increase value, despite the threat of financial distress.
CAPITAL STRUCTURE
List 4 arguments why in the reality financing does metter
o Taxes – tradeoff theory
o Differences in information – pecking order theory
Managers issue equity when they see that there is asymmetrical difference between managers and shareholders. In case that managers consider that price of shares is too high they will issue equity otherwise, it is more reasonable for the company to issue debt.
o Agency costs – free cash flow theory
o In case that managers use company’s money in a unreasonable manner, equity-holders will perform an LBO, which will increase the debt level of the company and will tend to limit managers’ expenditures.
o Innovation –“if new securities or financing tactics didn’t matter, they wouldn’t appear”
CAPITAL STRUCTURE
In general, industry debt ratio is low when
o Profitability and business risk are high
Riskier firms tend to borrow through equity, because otherwise they would have to face high cost of debt.
o Growth opportunities are valuable
Growing companies rather tend to issue equity than debt, because debt restricts their investment choices.
CAPITAL STRUCTURE
Why due to pecking order theory equity holders invest in risky assets
They understand that they have nothing to lose
EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
What determines firms’ target debt ratios?
Tax exposure (weak explanatory power) Cash flow Volatility↑ -> D ↓ Firm’s size↑ -> D ↑ Assets tangibility/liquidity (fixed assets/TA)↑ -> D↑ M/B ratio↑ -> D↓ Product uniqueness↑ -> D↓ Industry effects Firm fixed effects
EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
How does tax exposure determines target debt ratio
Tax shields do affect financing when they change marginal tax rate
EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
How does Cash flow Volatility determines target debt ratio
Higher systematic risk - > lower debt ratios
EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
Why small firms have smaller Debt
1) High costs of refinancing for small companies
2) Size correlates with other factors that affect D/E ratio
(diversification, volatility of CFs, probability of bankruptcy, etc.)
3) Large firms -> easier to sell assets in case of bankruptcy + good reputation
-> banks are more willing to provide credit
4) Large firms -> better access to public debt markets
EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
Why does higher Assets tangibility/liquidity (fixed assets/TA) determines target debt ratio’s rise
1) Tangible assets better preserve their value during default
2) Tangible assets are more easily redeployed
3) More tangible assets -> Debt-equity problems ↓
EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
Why does higher M/B ratio determines target debt ratio’s downwards
1) higher M/B -> prospects for growth -> use retained earnings
2) Overvalued equity -> issue more equity
BUT the relationship is partly mechanical (high equity causes more equity in capital structure)
EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
Why does higher Product uniqueness determines target debt ratio’s downwards
Non-financial stakeholders are concerned about financial health
(workers, customers, suppliers)
EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
What is industry effect on Debt ratio
Competitive industry -> low debt ratio to survive price wars
EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
What is firm fixed effect
Management preferences, governance, geography, competitive threats,
“corporate culture”, etc.
EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
What causes firms to deviate from the
target debt ratios?
1.Profitability
2. Market timing
3. Past stock returns (if high -> less debt)
4. Managerial preferences and
entrenchment
EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
How does profitability causes firms to deviate from the
target debt ratios?
• Pecking order theory -> higher profits-> less debt • BUT also More profitable firms -> higher tax exposure -> more debt • Profitability might be a proxy for asset productivity • Profitability as a proxy for CEO power -> managerial preferences
EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
How does market timing causes to deviate from the
target debt ratios
• Taking advantage of mispricing
• New equity issued when Co shares
are overvalued in the market
EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
How do Past stock returns cause to deviate from the
target debt ratios
• High stock returns recently
- > high growth opportunities
- > equity is high-priced
- > issue more equity
EMPIRICAL CAPITAL STRUCTURE: A REVIEW How do Managerial preferences and entrenchment cause to deviate from the target debt ratios
• Equity vs. debt holders problems • Agency problems -> low debt, if managers have the discretion to organize “easy life” for themselves • Managers own a lot of stock & options (agency problems ↓) -> more debt • If powerful CEO -> debt ratios likely to reflect managerial preferences
EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
What are the consequences of leverage
for customers?
- Debt may damage the firm-customer relationship, leading to poor performance
- In case of industry downturn -> highly leveraged firms +high R&D -> sales↓
- Overleveraged firms are less likely to survive industry deregulation
