Theory Flashcards
(149 cards)
1
Q
Name the corporate finance models of lu1
A
Shareholder model (only FV)
Refined shareholder model (FV + b * Sv + C * EV) (B and C < 1)
Stakeholder model = FV + b* Sv
Integrated model FV + SV + EV
2
Q
What are externalities
A
Cost or benefits created by the organisation that are borne by others
3
Q
How do we align FV, SV and EV?
A
Charge ‘‘true prices’’ that include hidden EV and SV
4
Q
Why is integrated value advantageous for companies?
A
Ethical case -> companies are expected to be ethical, both by employees and consumers
Business case -> Companies that create SV and EV are more likely to be healthy FV-wise in the long run
5
Q
Four driving forces between internalisation of SV and EV into FV
A
License to operate
Regulation and taxation
Technological advancement
Customer preferences
6
Q
Formula for expected transition losses (ETL) for company i in sector j (ETLij)
A
ETLij = EATij * PT * LGT
EAT = exposure to transition
PT = probability of transition
LGT = loss given transiction
Can be further broken down into
b * vi * pt * (1-a)
With b = level of transition in sector j, and
vi = value of company i
a= adaptability of company a
7
Q
Current and future benefit should be treated the same. If so, why is there even a discount rate for social/environmental value?
A
Growth rate of consumption and elasticity of marginal utility of consumption
so accounting for productivity and consumption increases ( I think )
8
Q
Name social factors
A
Labour practices
combatting poverty
Interaction with commonuities
9
Q
Name environmental factors
A
Pollution
Use of scarce resources
Restoration of nature
10
Q
How to calculate consumer surplus?
A
DeltaP * Q * 1/2
So difference between current price and price where Q = 0
Somewhere else it says Sales / Price elasticity * 1/2
11
Q
Name two types of valuation
A
Relative valuation (e.g., P/E)
Absolute valuation (E.g., DCF)
12
Q
What could be a problem with relative valuation and integrated value?
A
It doesn’t account for integrated value and future performance as a result of possibly lacking EV and SV.
13
Q
What is a problem with measuring integrated value?
A
We can hardly measure sustainability -> ESG ratings are poor, so we need to go deeper
14
Q
Describe double materiality
A
Financial materiality only looks at how E and S values can impact finance -> e.g., by decreasing long-term cashflows?
Impact materiality only looks at outward impact, so co2 emissions
Double materiality equals integrated value, you look at FV + EV + SV = IV
So you don’t only take into account possible future effects on FV, but you take the values into account separately.
15
Q
What are steps for calculating integrted value?
A
1 Analysing social and environmental factors (purpose + stakeholder map)
2 Materiality
3 Quantification
4 Monetisation
5 Integrated valuation
6 Conclusions
16
Q
What is the 2.2% discount rate made up of?
A
2% social discount rate
0.2% risk premium
17
Q
What is the paradox for strong form EMH?
A
For strong form EMH, all information is incorporated immediatly, and thus stock analysis has no use.
However, information can only be incorporarted through analysis / information discovery.
18
Q
What valuation methods are best for integrated value?
A
Fundamentals -> better understanding of company
Comparables lack detail
19
Q
Summarize adaptive markets hypothesis
A
Price efficiency of markets depends on number of analysts + quality of analysis -> can lead to inefficiences and not fully incorporating S&E values
20
Q
Debt to equity ratio
A
D/E
21
Q
Debt to value ratio
A
D/(D+E)
22
Q
How does S&E relate to MM propositions?
A
Financially material S and E externalities are already incorporated in the basic MM model
Because future cashflow predictions incorporate the possibilities of impacts
However, if we know there will never be a carbon tax, the externalities are not financially material, thus not incorporated.
23
Q
How should we record unpriced positive and negative externalities on an integrated balance sheet?
A
Positive externalities are assets, negative externalities are debt
23
Q
Explain economic and financial distress
A
A firm that makes significant losses is in economic distress
Whether economic distress results in in financial distress depends on the firm’s leverage
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What are direct cost of bankruptcy?
Legal expenses, court costs, advisory fees
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What are indirect costs of bankruptcy?
Missed investment opportunities
ability to compete in product markets
Loss of customers, employees and suppliers
Fire sale of assets
Delayed liquidation
Loss of receivables
costs to creditors
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Explain who bears financial distress costs (hint: ex-post; ex-ante)
Ex-post; debt holders pay for the cost of financial distress.
However, this is priced in ex-ante with higher interest rate to keep ER for debt holders acceptable
So shareholders pay the cost of financial distress if they need to raise new financing. But if debt was issued in the past at a fixed rate, the value of debt will drop and thus debt holders pay the cost.
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What is the tradeoff theory?
Trading off the benefits of the tax shield to the costs of financial distress to find optimal capital structure
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Explain how debt can make equity resemble a derivative
Limited liability gives equity a call-option like payoff function
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Describe moral hazard in relation to debt
Shareholders may take excessive risk at the expense of debt holders. While firm value may decrease, equity value can increase because debtholders bear losses.
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Describe debt overhang
Shareholders may forgo positive NPV projects. They do this because positive NPV projects will mostly benefit debtholders in case of high leverage. So in contrast to risk shifting where negative NPV projects are chosen, positive NPV projects are foregone -> under-investment.
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Describe agency benefits of debt
-May incentivize owner to work harder than with equity financing
-Reduces wasteful spending by managers
If a company is highly leveraged managers have the incentive to operate in the best way for shareholders to not go bankrupt and lose their job
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Describe the participation constraint
The amount of equity investors need to break even, assuming high-effort.
So if payoff is 9.6m and financing requirement is 6m, you need a 6/9.6 = 62.5% stake
However, if a 37.5% stake for the owner is not sufficient to incentivize high-effort, this does not work.
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What happens if the share investors require will imply low effort?
The original owner/manager will pay for moral hazard, it's priced in.
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What is the leverage ratchet?
Shareholders may not reduce or even increase leverage even if that increases firm value
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Name IPO advantages and disadvantages
-Greater liquidity: private equity investors and initial foundres can diversify
-Better access to capital for the compnay itself
but;
-Equity holders become more widely dispersed making monitoring of the firm more difficult
-The firm must satisfy regulatory requirements
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Describe the types of underwriting agreements
-Best effort: no guarantee, best-effort to sell
-Firm commitment: guarantee to sell the stock; or buy it themselves
-Auction IPO: takes bids and then sets price in a way that clears the market (e.g., google 2004)
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Describe IPO underpricing and winne's curse
Stocks are being sold for less than they should be on average, large first-day gains, costing original shareholders
-an explanation for this is that good IPOs are oversubscribed and bad ones are undersubscribed. So, investment in good IPOs is rationed while fully investing in bad IPOs
-Furthermore, winner's curse is the saying that the highest bidder likely overestimated the value of the item being bid on. You win, but probably pay too much.
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What is the pecking order under adverse selection
Firms prefer to use cash, then debt then equity to finance investments
The least information-sensitive source of financing reduces the adverse selection costs (cross-subsidy from good to bad firms)
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Name two outcomes from the indistinguishable lemon principle
-Pooling equilibrium: both types of firms get same financing for the same price
-
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How can we solve cross-subsidiy due to moral hazards?
1. external equity financing -> stil cross subsididy
2. debt -> less so, but probably still cross subsidy
3. internal funds -> implies risk free debt, no cross-subsidiy as lemons will not want to invest themselves
4. collateral/risk-free debt -> same as before, debtors know its a good firm if it offers collateral
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Theoretically, dividend policy is irrelevant as shares should appreciate and investors can sell shares to free up cash. Why may investors still like dividends?
-Transaction costs: homemade dividends require time and fees
-Mental accounting: spend the interest, keep the principal
-Agency costs: commiting to dividends keeps manager from excessive spending
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What is a tax advantage for share repurchases compared to dividends?
-Capital gains are often less taxed
-Selling shares can be timed, dividends can't
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Explain dividend signalling
Dividend increase signals good earnings expectations, and decrease the opposite
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Indirect costs of financial distress
Indirect costs of financial distress
* Losing valuable (customers), employees, and suppliers in anticipation of financial distress
* Inability to invest into the right projects
* Inefficient liquidation of assets (i.e., below market prices because there is not much demand or too specific)
* Inability to respond to competition
Time and focus wasted on negotiating with creditors
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Describe the asset-substitution problem
Leverage incentivizes shareholders to replace low-risk assets with risker ones, despite possibly negative NPVs
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What is the the company’s integrated value (IV) equation?
Max IV: FV + SV + EV
The traditional goal is maximising financial value for shareholders. The goal function is broadened toward steering on financial value (FV), social value (SV), and environmental value (EV) in an integrated way.
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What are the four driving forces behind the internalisation of SV and EV into FV:
License to operate
Regulation and taxation
Technological advancement
Customer preferences
| Dynamic perspective, but timing is uncertain
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Why is it in companies’ interest to manage for integrated value?
| Two reasons
If company management neglects SV or EV, that will hurt long-term FV as well. Two reasons:
- Ethical case - license to operate -> corporate responsibility (case for SV and EV)
- Business case – long-term value creation (case for FV)
Companies that create value on SV and EV are more likely to be value creative on FV in the long run
As external impacts are being internalised, they affect FV
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I. Planetary Boundaries
What is the purpose of the planetary boundaries?
A. Defines the limits in nine areas of the planet which humanity must not exceed to maintain a liveable planet.
B. Outlines the maximum GDP levels beyond which climate change will be irreversible.
C. Shows the amount of import / export that a country should not exceed, to protect domestic companies.
D. Indicates the annual date when the earth’s yearly resources have been exhausted.
A. Defines the limits in nine areas of the planet which humanity must not exceed to maintain a liveable planet.
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II. Integrated shareholder model
How does the integrated stakeholder model differ from the traditional version?
It recognises that good relations with stakeholders might boost financial firm value.
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III. Social and ecological value creation
A company that generates economic profits, will likely...
A. Create social and ecological value.
B. Destroy social and ecological value.
C. Create social value but destroy ecological value.
D. Destroy social value but create ecological value.
E. All of the above are possible.
E. All of the above are possible.
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IV. Price Internalisation
If the negative externalities of a product are internalised into the price, but the cost of sales remains the same, how does a firm’s gross profit margin change?
A. Increase
B. Decrease
C. Remain
D. Not possible to say based on the provided information.
A. Increase
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V. Corporate Governance
Which of the following broad statements about corporate governance issues is false?
A. The two core problems of corporate governance aggravate one another.
B. Information asymmetry can be broken by social and ecological reporting.
C. Amount of debt does not impact the main corporate governance problems.
D. Corporate governance must consider non-financial factors.
B. Information asymmetry can be broken by social and ecological reporting.
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VI. Governance and company value
How does governance impact the valuation of a company?
Strong governance reduces the risk of a firm and accordingly its cost of capital.
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Why are EV and SV necessary when there is already FV
EV and SV focus on externalities that are not priced in FV but are necessary. Regulation will not be perfect
* Record unpriced positive externalities as assets
* Record unpriced negative externalities as debt
* Residual value is equity = net externality
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What are examples of priced E and S externalities that are financially materialised
* (Expected) carbon pricing and other regulations
* Consumers’ higher willingness to pay for environmentally friendly products
* Positive reputational effects on marketing and brand
* Technological risks associated with operating carbon-intensive assets
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What is value creation? And what is the difference in value creation for a responsible company and "irresponsible" company
In financial terms, value creation is defined as an increase in the net present value (NPV) of a company’s projects
Currently, FV is often generated at the expense of SV and EV as resources are depleted without sufficient investments in maintaining them
Responsible companies manage for integrated value creation (profit and impact) rather than merely shareholder value (profit)
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What is the the planetary boundaries framework? How would integrating SV and EV for companies around to world help manage this framework?
It is defined a safe operating space for humanity within the boundaries of 9 productive ecological capacities of the planet
The planetary boundary lies at the intersection of the green and orange zones
Currently, many companies are value destructive on SV or EV. For society and the economy to operate within social and planetary boundaries, we need companies on aggregate to stop being value destructive on SV and EV
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What are external impacts (also called externalities)?
They are costs or benefits that are created by organisations or persons but whose costs are borne by society as a whole
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What is the difference between a succesful and unsuccesful transition
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What is the formula to calculate expected transitionloss
Expected transition loss =
B = between 0 and 1. if b is very small the industry is not in transaction, 1 whole sector is moving
PT = how likely will it happen
LGT = if it happens, how quick is your loss
(1-a) = a: 0, not prepared at all (working in an old economy), fully prepared a = 1
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What does the societal discount rate consist of?
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How do we measure SV and EV?
| *Value flow formula and dcf formula
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Example: What are the steps of calculating the value flow of a carbon emission project?
| * from CF to VF
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Example: What are the steps of calculating the IV of a project?
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What are the three steps in the value calculation for SV and EV
1. Materiality assessment - determine important SV and EV factors;
2. Quantification - express these factors in their own units Q; and
3. Monetisation - express these factors in money with shadow prices SP
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What are three core set of factors which should always be included in the materiality assessments to determine which S and E factors are important
Greenhouse gas emissions - including carbon emissions
Labour practices - including discrimination and inclusion
Business ethics - including corruption and fraud
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How do you calculate the consumer surplus? and what is it used for?
Well-being of customers – calculated as consumer surplus, which is the difference between the price of a product and what consumers want to pay
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How do you define shadow prices
- Shadow prices reflect the ‘true scarcity’ of resources to stay within planetary boundaries
- Organisations such as the Impact Economy Foundation and True Price provide regularly updated lists of impact and shadow prices (see Appendix of Chapter 5)
True prices are based on two welfare categories:
* Rights (human, labour and environmental rights)
* Well-being
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perpetuity formula
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What are the responsibilities of the General Partner (GP), Investment Manager and Limited Partners (LPs) within a PE
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What is the cost of capital of each company
a) The WACC of A: 5% - calculated as 90/150*3% + 60/150*8%
b) The integrated cost of capital of B: 4.5% - calculated as 90/180*3% + 60/180*8% + 30/180*2%
c) The integrated cost of capital of C: 6.5% - calculated as 90/100*3% + 60/100*8% + -50/100*2%
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How do you calculate customer wellbeing value flow?
(sales/price-elasticity)*0.5 50% attribution
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How do you calculate empoyee wellbeing value flow?
Well-being of employees – additional to the salary received, measured by life satisfaction points (on a scale of 0 to 100)
number of employees*points*SP
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How do you calculate carbon emission value flow?
mn metric of tons * quantity
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I. Materiality
What is NOT true regarding materiality?
A. Materiality looks at all potential impacts on people and environment
B. Materiality changes over time
C. Materiality differs per country and industry
D. Labour practices and business ethics are always material
A. Materiality looks at all potential impacts on people and environment
Materiality assessments aim to determine which S and E factors are sufficiently important for consideration in SV and EV. Material social and environmental topics are those that reflect a company’s most significant impacts (positive or negative) on people and environment. This is the outward impact of Fig. 2.5 in Chap. 2. Given the impact on a company’s stakeholders and wider society, stakeholder engagement is crucial for companies to understand and determine materiality.
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II. Consumer surplus
Assuming a company has a revenue of €200 million and a price elasticity of demand of 1.67. What would be the estimated consumer surplus?
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Assumptions Behind the MM Propositions
No taxes and financial distress costs, no asymmetric information, no transaction costs, managers
and employees always work to maximize the value of the firm, individuals and firms can borrow and
lend at the same rates
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MM Proposition 1:
In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.
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Modigliani-Miller (MM) Proposition 2
## Footnote
Let 𝐸 = market value of equity, 𝐷 = market value of debt, 𝑈 = market value of unlevered equity, and 𝐴 =market value
of the firm’s assets
MM Proposition 2: The cost of capital of levered equity increases with the firm’s market value debt-equity ratio
82
Consider a polluting firm that risks being subject to a high carbon tax in the future
Given the simplified assumptions in MM, would this be reflected in firm valuation and cost of capital in the MM model?
The cost of financially material E and S externalities on financial capital structure is already captured in
the basic MM model
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What are 5 fallacies related to capital structure that Modigliani-Miller helps to address
1. Debt is Cheap Fallacy
2. EPS Fallacy
3. Equity Issue Dilution Fallacy
4. Repurchases vs Dividends
5. Cash Hoarding
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(1) Fallacy: ”Debt is cheaper than equity because it has a low interest rate”
What is wrong with this argument?
WACC will stay the same
* increasing leverage comes at the cost of increasing the cost of equity capital
* Increasing leverage to a point where debt is risky, the required return on debt also increases
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(2) Fallacy: “Debt is desirable when it increases earnings per share (EPS)”
This fallacy implies that leveraging through debt always increases earnings per share (EPS). However, it ignores the financial risks and costs of debt, which might not necessarily result in increased EPS. While EPS in example has indeed gone up, so has the risk and therefore required return on equity. Moreover, while EPS might increase, the share price might not increase.
* EPS can go up (or down) when a company increases its leverage ⇒ true
* Companies should choose their financial policy to maximize their EPS ⇒ false
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(3) Fallacy: ”Equity is more expensive than debt because equity issues dilute the earnings per share and drive down the stock price”
* Equity issuance = flipside of repurchase → reduction in leverage
We have seen that earnings per share are indeed lower when leverage is lower
* But the value of the shares is the same; extra EPS in levered firm is compensation for risk
* Original shareholders are not worse off when issuing shares
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(4) Fallacy: ”Paying out cash through share repurchases is better than dividends because repurchases support the share price.”
There is no "Mechanical effect" that shows why is better than the other.
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(5) Fallacy: “The company should pay out its cash rather than just invest in government bonds at a low interest rate. This would increase investor returns.”
* Overall, payout policy does not matter under MM if retained cash flow earns a fair market return
The payout policy argument is the same as the debt irrelevance argument
* Important principle: deciding how much debt to take on and deciding how much cash to pay out is
essentially the same decision
* Cash = Negative Debt!
* This is why we should consider Net Debt = Debt – Excess Cash when we evaluate capital structure
(see your valuation course).
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What is the tradeoff theory?
MM debunks the “debt is cheap” and many other fallacies
* The picture changes once we introduce taxes and bankruptcy cost
* Now the government wants its slice as well
* If taxes are paid on earnings after interest payments, debt is cheaper than equity financing
* But high leverage increases bankruptcy cost → trade-off theory
* Tradeoff Theory: the firm picks its capital structure by trading off the benefits of the tax shield from debt against the costs of financial distress
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How do you calculate the tax schield
Interest tax shield = (corporate tax rate) × (interest payments)
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What is the updated MM Proposition 1 (with taxes)
the total value of the levered firm exceeds the value of the firm without
leverage due to the present value of the tax savings from debt:
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What is the MM Proposition 2 with taxes
With tax-deductible interest, the effective after-tax borrowing rate is
𝑟(1 − 𝜏c) and the weighted average cost of capital becomes:
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What is the The low Leverage Puzzle
If capital structure was only about taxes, firms should have relatively
high leverage
* This is not the case: it would appear that firms, on average, are underleveraged.
* There seems to be more to the story:
* Bankruptcy costs
* Agency costs
* Asymmetric information costs
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MM does account for financial distress & bankruptcy. However, there is an important assumption they make
MM assumption: when the value of equity falls to zero (limited liability), debt holders take over the firm at no cost
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When a firm fails to make a required payment to debt holder this is called default. what are the two bankruptcy proceedings?
Bankruptcy proceedings
* Liquidation: sell all assets of the firm and use the proceeds to pay debt holders
– For large firms, this is very costly and takes a long time
* Reorganization: management proposes reorganization plan and continues to operate the business
– Goal is to continue operating the firm rather than liquidating all assets
– Creditors receive cash payments and new securities in firm and can vote to accept/reject the plan
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Financial vs Economic Distress
| Difference
A firm that makes significant losses is in economic distress
* Whether economic distress results in financial distress depends on the firm’s leverage
* An all-equity (unlevered) firm can be in economic distress, but it will never face bankruptcy
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What are the three key factors determine the present value of financial distress costs
1. The probability of financial distress
* Increases in leverage, cash flow volatility and asset volatility
2. The magnitude of the costs after a firm is in distress
* Direct + indirect costs
* Higher for firms with more intangible assets and important employee and customer relationships (e.g. technology firms)
3. The appropriate discount rate for the distress costs
* Depends on the firm’s market risk
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What are some examples of indirect costs bankruptcy
* Missed investment opportunities
* Ability to compete in product markets
* Loss of customers, employees and suppliers
* Fire sale of assets
* Delayed liquidation
* Loss of receivables
* Costs to creditors
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Why is there no agency conflict with debt?
no agency conflict with debt: the owner/manager exerts high effort whenever it has higher NPV
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What is the Free Cash Flow Hypothesis in agency problem context?
Additional (informal) argument for why higher leverage reduces wasteful spending by managers
* Idea: wasteful spending is more likely to occur when firms have high levels of cash flow in excess of what is needed after making
all positive-N P Vinvestments and payments to debt holders.
* When cash is tight, managers will be motivated to run the firm efficiently ⇒ contrast to #4-2, Fallacy 5: Cash Hoarding!
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What implictions does adverse selection have for firm financial choices
Pecking order: to reduce adverse selection problems, firms may prefer to first issue the least-information sensitive securities
* Signaling: firms may engage in costly signaling (for example, posting collateral) to convince investors they are a good firm
* Equity issuance cost and market breakdowns: investors may perceive a firm announcing an equity issuance as over-valued,
resulting in a negative stock price response.
* Winner’s curse: IPOs tend to be underpriced because investors may be concerned about buying into a bad firm
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What is Adverse selection?
asymmetric information about the type of an individual/asset/firm/…
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What are limited partners in PE/VC?
hold shares in the VC firm but have limited voting rights
* Often institutional investors such as pension funds, insurance companies, mutual funds
* Investing in venture capital firms, limited partners benefit from diversification and the expertise of the general
partners in selecting firms
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What are General partners (GPs): in PE/VC?
managers of the VC firm (“Venture capitalists”)
* Earn fees paid by limited partners
* General annual management fee (usually around 2% of the fund’s committed capital)
* Carried interest: 20%-30% of any positive return they make
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The idea that when a seller has private information about the value of goods, buyers will discount the price they are willing to pay due to adverse selection is known as the
lemons principle
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What is Preferred stock
Its issued by young companies has seniority in any liquidation but typically does not pay regular cash dividends and often contains a right to convert to common stock.
* Different from preferred stock issued by mature companies, which usually has a preferential dividend and
seniority in any liquidation and sometimes special voting rights.
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What is Convertible Preferred Stock
Preferred stock that gives the owner an option to convert it into common stock on some future date
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What are ways VC's gain bargaining power in negotiating?
Terms depending on bargaining power (e.g. better terms for start-up in up rounds):
* Liquidation Preference: minimum amount paid to preferred stock before common stock in liquidation
* Seniority: over investors in earlier rounds
* Participation Rights: liquidation preference and rights to payments to common shares
* Anti-Dilution Protection: right to purchase common stocks at better price in down rounds
* Board Membership: investors appoint board members to secure control rights and prevent moral hazard
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What is a Special Purpose Acquisition Companies (SPAC)
SPACs first raise financing in an IPO, and then find a private firm to merge with
Thereby, SPACs take private firms public
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What is a syndicate
A group of underwriters who jointly underwrite and distribute a security issuance
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What is a Seasoned Equity Offering (SEO)?
SEO: a public company offers new shares for sale to raise additional equity
* Main difference to IPO: market price for the stock already exists, so the price-setting process is not
necessary
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What are the two types of SEO offerings
* Cash Offer: firm offers the new shares to investors at large
* Rights Offer: firm offers the new shares only to existing shareholders
protects existing shareholders from underpricing
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What is the IPO/SEO underpricing Puzzle
Generally, underwriters set the issue price so that the average first-day return is positive
* About 75% of first-day returns are positive
* The underwriters benefit from the underpricing because it allows them to reduce risk
* The pre-IPO shareholders bear the cost of underpricing
* In effect, these owners are selling stock in their firm for less than they could get in the aftermarket
LINK TO WINNERS CURSE
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What is the puzzle around high IPO/SEO underwriter fees
A typical spread is 7% of the issue price!
* This is a large fee, especially considering the additional underpricing cost
* One possible explanation is that by charging
lower fees, an underwriter may risk signaling that it is not the same quality as its higherpriced competitors
* Although not as costly as IPOs, SEOs are still expensive: underwriting fees amount to 5% of the proceeds of the issue.
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What is the IPO/SEO Cyclicality Puzzle
The number of issues is highly cyclical: in good times, the market is flooded with new issues; in bad times, the number of issues dries up
* What is surprising is the magnitude of the swings
* Unlikely explained by swings in available growth opportunities alone
* Cyclicality in the supply of capital likely plays a role too
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What SEO Price reactions Puzzle
On average, the market greets the news of an S E O with a price decline
* The stock price tends to rise prior to the announcement of an equity issue
* Firms tend to issue equity when information asymmetries are minimized, such as immediately after earnings announcements
* All consistent with adverse selection (see formal model)
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Pecking order: under adverse selection about the quality of new investments, firms prefer to first use the least information-sensitive sources of financing
What is the order that they use?
1. Internal resources (cash, retained earnings)
2. Senior debt (with little default risk)
3. Junior debt, convertibles
4. External equity
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What are the Implications for Equity Issuance (SEO Price Reaction Puzzle)
The stock price declines on the announcement of an equity issue: market suspect the issuing firm may be a lemon
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What is the tradeoff theory?
Tradeoff theory tells us the firm should balance the cost of financial distress against the benefit of the tax shield
* (+ other agency costs/benefits)
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What is the Leverage Ratchet Effect
Once existing debt is in place...
1. Shareholders may have no incentive to decrease leverage, even if it increases firm value
2. Shareholders may have an incentive to increase leverage even if it decreases firm value
Leverage Ratchet Effect: over time, this can lead to a gradual increase in leverage
⇒ can explain many contractual features in debt contracts often observed in practice, such as: short maturities, restrictive covenants, collateral, …
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What is moral hazard
* Shareholders have control over the firm’s actions
* But shareholders’ actions are unobservable and therefore not contractible
* Even if shareholders want to commit to a certain action, they cannot write a contract that can enforce this action
* Any action needs to be incentive-compatible
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What are ways that overcome commitment problems?
| Lev. ratchet implies firms cannot commit to a future capital structure
To overcome the commitment problem, firms/creditors use:
* Shorter maturities → automatic reduction in leverage
* Collateral → exclusive access to asset, not vulnerable to future leverage changes
* Seniority provisions → avoid dilution through new debt issuance
* Restrictive covenants → prohibit increases in leverage (at cost of lower operational flexibility)
* Relationship banking → bank has market power over borrower
* Reputation building → overcome commitment problem by building a reputation
140
What are the three types of Agency costs?
Agency costs
* Leverage Ratchet Effect: excessive leverage can build up over time
* Excessive risk-taking (risk shifting)
* Under-investment due to debt overhang
141
Why would shareholders prefer a value-destroying (lower/negative NPV) project?
The key is limited liability: when the firm defaults (state L), shareholders’ payoffs are capped at 0
* Yet in state H, shareholders enjoy the entire benefit from higher payoffs
* Shareholders can shift risk on debt holders: “Heads I win, tail you lose”
Stronger incentives to take excessive risk if
* Firm has large outstanding debt levels (high 𝐷)
* Firm can shift value from default states to non-default states (high risk sensitivity 𝑉" − 𝑉$)
142
Why can equity seen as a call option on the firm’s assets with strike
price (1 + r)𝐷
Equity represents ownership in a company and is likened to a call option on the firm's assets. A call option gives the holder the right (but not the obligation) to buy an asset at a predetermined price (the strike price) by a certain date.
Limited liability gives equity a call option-like payoff function
143
Why is risky debt like risk-free debt with face value 𝐷 and a short position
in a put option on the firm’s assets with strike price(1 + r)𝐷:
Risky Debt as a Short Position in a Put Option: Risky debt holders are compared to being in a short position in a put option on the firm's assets. A put option gives the holder the right (but not the obligation) to sell an asset at a predetermined price (the strike price) by a certain date.
144
Limited liability gives equity a call option-like payoff function, what does this lead to?
* As a result, shareholders have an incentive to invest in risky projects and shift risk on debt holders
* Anticipating this behavior, debt holders charge higher interest rates ex-ante
* To avoid high interest rates, shareholders would like to commit to less risky projects ex-ante
145
What prevent banks from levering up too much and taking excessive risk ?
financial regulation mandates high capital requireme
146
What is debt overhang?
Bottom line: shareholders may prefer to forgo positive-NPV investments, even though they would increase firm value
