Tutorial 1:How macroeconomic conditions can influence firms’ ability to raise capital?

Question 1

When there is a recession, how does the quantity of capital firms demand change?

Answer 1

1) Reduced investment opportunities –> econ. downturn & reduced consumer demand –> decreased need to invest in expansion plans & projects –> decrease in firms’ capital demand –> may not require as much external capital funding.

2) Internal funds dry up –> econ. downturn & reduced consumer demand –> reduced profitability & cash flows within firms–> firms less able to finance investments using retained earnings –> may increase firms’ reliance on external financing options e.g. debt or equity issuance to sustain business activities.

3) Increased demand for external capital –> econ. downturn & reduced consumer demand –> firms may be forced to rely on external capital to cover associated expenses to sustain business activities (e.g. operating expenses/exploiting new investment opps.) via debt or equity issuance.

Question 2

When there is a recession, how does the type of capital firms demand change?

Answer 2

Recession may increase info asymmetries/frictions (i.e. increased uncertainty, financial distress, market volatility, credit constraints, behavioural biases e.g. herding) –> firms issue less info-sensitive securities to mitigate impact of asymmetric info on their capital raising activities e.g. to mitigate concerns about signaling adverse info to mkt or facing challenges in pricing securities accurately –> order of capital type issued: Debt (least info-sensitive) >Convertibles (equity-debt hybrid)>Equity (most info-sensitive as involves ownership stakes in company).

Question 3

When there is a recession, how does the quantity of capital supplied by investors change?

Answer 3

• Recession may increase info asymmetries/frictions –> investors less able to obtain timely & accurate info about firms’ financial health/fundamentals –> may also be lack of transparency in mkt, making it difficult for investors to assess investment opportunities accurately.

1) Reduced capital supply –> investors may be more cautious & risk-averse in econ. downturn –> reduced investor confidence –> investors less willing to supply capital to firms, especially to firms w higher perceived info asymmetries –> may constrain firms’ ability to raise funds & finance projects, made worse by potentially tighter credit conditions.
2) Increased cost of capital (COC)–> as investors become more risk-averse & demand higher returns to compensate for increased uncertainty, COC tends to increase –> firms seeking to raise funds may face higher financing costs in accessing external capital –> may further deter investors from supplying funds, particularly to riskier ventures or firms with weaker credit profiles.

Question 4

When there is a recession, how does the type of capital supplied by investors change?

Answer 4

–> Flight-to-quality: investors are more risk averse & prefer safer assets due to econ. uncertainty.
–> Prefer: Debt (fixed income streams; lower volatility)>Convertibles>Equity.
–> Firms may need to adjust their capital structure to align w investors’ risk preferences & market conditions.

Question 5

How is capital raising impacted between investment grade & non-investment grade firms during a recession?

Answer 5

• SUPPLY OF CAPITAL SHIFTED TOWARD LESS RISKY SECURITIES, WHICH DEPENDS ON CREDIT QUALITY OF FIRM:
• Investment-grade firms: countercyclical capital raising activities i.e. access to external financing/securities issuances do not decline during recession.
  –> due to higher credit ratings & lower perceived risk –> experience less volatility in capital raising activities as investors maintain confidence in their creditworthiness & continue to invest in their securities –> benefit from flight-to-quality effect during recessions, where investors seek safer assets –> equity issuance does not decline ; bond issuances increase ; private loans issuance does not decline –> benefit from increased demand for their higher-rated securities.
• Non-investment grade firms: procyclical capital raising activities i.e. access to external financing/securities issuances decreases during recession –> due to lower credit ratings & higher perceived risk –> greater difficulty of firms accessing capital markets so reduced availability of external financing sources –> greater difficulty in raising capital as investors become more risk-averse & prefer safer investments so decrease demand for securities –> decreased investment opportunities –> equity issuances decrease ; bond issuances decrease ; private loan issuance decrease –> firms shut out of capital mkt.

Question 6

How are investment-grade firms’ cash holdings impacted by the flight-to-quality effect during a recession?

Answer 6

Flight-to-quality hypothesis: investors are risk-averse & seek safer investments during econ. downturns, leading to higher demand for securities issued by investment-grade firms w higher credit rating & lower default risk –> these firms more likely to maintain larger cash reserves as strategic financial management practice i.e. to mitigate financial risks, ensure liquidity & demonstrate financial stability to investors –> increased demand for their securities allows them to issue bonds or raise capital more easily & at favorable terms.

Question 7

How do the costs of capital of investment-grade & non-investment grade vary during a recession?

Answer 7

• Investment-grade firms (higher credit rating): lower financing costs compared to non-investment-grade firms due to higher credit ratings –> can access capital at more favorable rates due to flight-to-quality effect –> lower cost of capital –> more able to raise capital to replenish liquidity.
• Non-investment grade firms (lower credit rating): higher financing costs due to higher perceived risk levels, exacerbated during recession –> difficulty in refinancing existing debt/issuing new securities at favorable terms during recessions –> higher costs of capital & limited funding options –> only raise capital when necessary & spend immediately.