Week 7 - How much should a firm borrow? (Capital structure IV)

Question 1

Conclusions for symmetric information & asymmetric information

*Asymmetric info - managers know the true state before the investing & financing decision is taken. Outside investors don’t know the state, but know that managers know. (common knowledge)

Answer 1

Under symmetric information, regardless of risk:
1. All positive NPV projects can be implemented
2. When uncertainty is realised, old shareholders may win or lose, but there is NO efficiency loss. They get the full NPV in expectation.

Under asymmetric information:
1. Investors can’t tell the quality of the firm
2. POOLING together with bad firms gives a low price for good firms.
3. This creates an ADVERSE SELECTION PROBLEM: when quality is unobserved, only poor quality goods are sold. In this example, only bad firms issue equity.
4. EFFICIENCY LOSS: good firms with positive NPV projects can’t be financed

Question 2

Primary vs Secondary offering

Answer 2

Primary offering - when a FIRM issues NEW stock to the public (to raise money)
- The number of shares, the total value of equity, and the total value of the firm increases
- CHANGES capital structure

Secondary offering - when one SHAREHOLDER sells a large BLOCK of stock to another shareholder.
- The firm is not involved in this transaction, so no change in the number of shares
- Firm’s capital structure UNCHANGED

Question 3

Pecking order theory

Answer 3

When financing projects, firms prefer to use the LEAST information-sensitive securities first.
Logic: if the value of a security depends a lot on your PRIVATE INFORMATION, it suffers from adverse selection problems. The issue of securities is a SIGNAL that those securities are overpriced.

1. Least sensitive: Retained earnings (cash), risk-free debt
   - Cash on hand/Retained earnings are cheaper than external financing b/c then the firm isn’t forced to forego +ve NPV projects
   - The value of debt is LESS SENSITIVE to private info than equity
2. Median: Risky debt
3. Most sensitive: Equity

Question 4

Agency problem & intuition

Answer 4

Managers may be SELF-INTERESTED and exploit equity investors
- They only bear a small cost (proportion to their {low} ownership) but they enjoy the FULL BENEFIT

1 solution: align managers’ incentives w/ interests of shareholders
eg. debt financing rather than equity financing

Question 5

Agency costs of outside equity aka Effort problem + Intuition

How to calculate whether a manager will choose to work hard under certain equity FINANCING TERMS?

Why does debt financing maximise managers’ incentive to exert effort?

Answer 5

• Conflict of interest between inside (managers) & outside equity holders (all other EHs)
• More outside equity reduces the incentive for managers to exert effort, reducing firm value.
  Hence, more outside equity => lower firm value

Intuition: To create value, managers must exert effort. Managers bear the full cost of effort supply, but the benefits of these efforts are shared w/ outside EHs.

2. Expected payoff from high effort ≥ Expected payoff from low effort
   equiv. to Proportion of marginal benefit from high effort ≥ marginal cost that she needs to pay (ie. PRIVATE cost of high effort)
3. The fraction of the return from effort that accrues to managers is larger w/ debt financing than equity.
   Implication: a leveraged recapitalisation (=firm borrows money to buy back shares) can be value-enhancing even in the absence of taxes
   » Increasing leverage (-> managers exert more effort, higher expected value of project) decreases the agency cost of outside equity b/c it aligns the payoff to the managers with their cost of effort (from PS7)

Question 6

What kind of companies are more likely to suffer from the AGENCY PROBLEM? aka Agency problem of free-cash-flow

What is the solution?

Answer 6

Companies that produce lots of FREE CASH FLOW.
FCF can potentially be wasted by managers on personal perks or vanity projects

Solution
1. DEBT is a legal obligation to pay out cash flow. If the co. goes bankrupt, the manager will often be fired.
- Managers are SELF-INTERESTED & will therefore have an incentive to work harder to ensure firm generates enough cash to meet interest payments
*Implications on capital structure: Optimal debt levels would generate just enough cash to pay interest & to finance all +ve NPV projects (ie. not so much that managers waste FCFs)
2. Why aren’t dividends & repurchases a solution?
- They could work but are imperfect; dividends are issued at the discretion of managers

Question 7

Summary - 4 theories for capital structure

Answer 7

Baseline: MM Capital Structure Irrelevance for perfect capital markets

When markets are imperfect, ie. all the time,
2. Trade-off theory
- Optimal capital structure balances the trade-off between TAX SAVINGS (& other benefits) and DISTRESS COSTS of debt (& other costs)

3. Pecking order theory
   - Avoid adverse selection costs of asymmetric information by financing using cash & risk-free debt first, then risky debt, then equity.
4. Agency theory
   - Use DEBT to alleviate manager vs shareholder agency problem & force pay out