Readings5 Flashcards
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
Empirical capital structure: a review
What are some deviations from the target leverage ratio?
- Profitability
• Higher profitability → less debt (pecking order theory) - Market Timing
• When a firm’s management thinks that its stock is cheap (market values high relative to book values), it may choose to take advantage of this mispricing - Stock Returns (Past stock returns ↑ → Debt ↓)
• the relation is to some extent mechanical → an increase in a firm’s stock prices will increase the
denominator of the debt ratio, thereby lowering the ratio
• High growth opportunities → equity highly-priced → fund growth opportunities with equity
• Managers tend to issue equity after stock price increases -> managers try to profit from their perceptions of mispricing - Managerial Preferences and Entrenchment
• Agency problems → managers may make a decision to take on less debt than shareholders
would prefer
• Powerful CEO → capital structure may reflect managerial preferences (management “style”)
• If managers own equity & stock options → increased willingness to take risk → more debt
Empirical capital structure: a review
What are the effects of leverage on stakeholders of the firm?
- Employees
• High leverage → lower wages, lower pensions funding, less job security during downturn
• High leverage → more frequent layoffs during recessions
• High leverage → labor unions less aggressive (labor union faces the choice of either accepting a lower wage or forcing the firm into bankruptcy and then negotiating with creditors) - Customers
• In case of industry downturn → high leverage in firms producing unique products → loss of customers
• In case of deregulations that ease new entry → competitions rises → firms with high leverage are less likely to survive - Suppliers
• Suppliers require lower rates of debt (protection against financial distress)
• In the industry with high R&D costs (unique products) suppliers require lower debt ratios - Competitors
• Highly leverages firms are forced to exit the market if the competition drives prices down during downturns
• Uniformly high level of leverage in an industry → higher prices + softer competition (in non recession times)
• Industries in which its rivals have low leverage (but the firm has high leverage) → lower sales growth of this firm - Investment decisions
• Debt as a discipline mechanism → reduced overinvestment among firms whose prospects are poor
• Debt overhang problem → highly levered firms pass up positive NPV investment opportunities
• The pressure to service large debt payments → encourages managers to choose investments that
generate higher immediate cash flows
• Debt covenant violations → creditors reduce firms’ access to finance + capital expenditures fall →
reputation is an important consideration for lenders
Corporate payout policy
What is the lifecycle theory?
Lifecycle theory
4 cycles of a company’s life:
1. & 2. Introduction & growth stages:
• Company has lots of lucrative investment
opportunities – requires cash
• Limited earnings
• -> company will tend to hold cash in the
company and keep payout ratio low
3. Maturity stage:
• Fewer or no investment opportunities with
NPV>0, earnings grow → pay out dividends
rather than waste cash on uncertain investments
• Likely agency costs→ impose higher dividends as
a disciplinary measure to prevent wasteful
investment
4. The firm decided whethe:
a) renewal
b) decline
Corporate payout policy
What is the residual theory?
Residual theory → simply assumes that
firms pay out excess cash as it arrives
Corporate payout policy
What are the factors stimulating payouts? Factors retaining payouts?
Factors stimulating payouts:
• investors pressure managers to accelerate cash payouts (avoid wasteful investment & managers’ personal benefits)
• 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
Factors retaining payouts:
• agency problems – managers make decision to keep cash
• tax advantages of deferred payouts
Corporate payout policy
What is the signaling theory using dividends?
- Share price increase at announcement of a dividend increase always reflects a reaction to a payout change
- Dividend policy is a communication device, which managers use to convey information to investors
Corporate payout policy
What is the empirical evidence about the signaling theory? How do the authors explain it qualitatively?
Empirical (quant) evidence: dividend changes are not useful in predicting future earnings changes. Changes in dividends tell us mostly about what has happened
• However, the relationship still holds (qual): 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.
• 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.
• Reason of reduction: 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
Corporate payout policy
Why are the managers reluctant to cut dividends?
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.
Reason of reduction: 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
Corporate payout policy
Why would managers strategically use dividend cuts?
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
