week 9 Flashcards
what is capital structure
the mix of debt and equity that it uses to finance its activities.
what is the optimal capital structure
¡The capital structure which maximises the value of
a company.
why do firms borrow if it involves extra risk?
by borrowing, a company may be able to increase the rate of return earned by its shareholders.
this effect is known as financial leverage which is measured by debt-equity ratio or debt-total assets ratio
If the rate of return on a company’s assets is greater than the interest rate on its debt
borrowing will increase the rate of return to shareholders.
vice versa
Financing a Firm with Equity
nUnlevered Equity
what does this mean
¡Equity in a firm with no debt
nBecause there is no debt, the cash flows of the unlevered equity are equal to those of the project.
what happens when the project’s cash flow will always be enough to repay the debt
the debt is risk free and you can borrow at the risk-free interest rate of 5%
Modigliani and Miller argued that
with perfect capital markets, the total value of a firm should not depend on its capital structure; the company is independent of its capital structure
describe the law of one price
the cash flows of the debt and equity equal to the sum to the cash flows of the project
Leverage increases the
therefore?
nthe risk of the equity of a firm.
investors in levered equity will require a higher expected return to compensate for the increased risk.
when The project cash flows depend on the overall economy
what exists? what will you do?
market risk
As a result, you demand a 10% risk premium over the current risk-free interest rate of 5% to invest in this project.
Leverage increases the risk of equity even when
there is no risk that the firm will default.
while debt may be cheaper, its use
_______
Considering both sources of capital together _________
raises the cost of capital for equity
. Considering both sources of capital together, the firm’s average cost of capital with leverage is the same as for the unlevered firm.
Modigliani & Miller Analysis
is based on what assumptions?
- Securities issued by companies are traded in a perfect capital market; this is a frictionless market in which there are no transaction costs and no barriers to the free flow of information.
- There are no taxes.
- Companies and individuals can borrow at the same interest rate.
- There are no costs associated with the liquidation or reorganisation of a company in financial difficulty.
- Companies have a fixed investment policy so that investment decisions are not affected by financing decisions.
MM’s Proposition 1
The market value of any firm is independent of its capital structure
if a company has a given investment policy, then changing its ratio of debt to equity will change the way in which its net operating cash flows generated by assets are divided between lenders and shareholders, but will not change the total value of the cash flows.
- Regardless of how they are divided, their total size remains the same. Therefore, the value of the company’s assets remains the same.
- that the firm’s total cash flows still equal the cash flows of the project, and therefore have the same present value.
- Therefore, the value of the company will not change.
Proposition 1: Proof
nTwo companies that have the same assets but different capital structures are, under the assumptions, perfect substitutes. As such, perfect substitutes should have the same value.
Proposition 1: Proof
what can investors create?
The proof provided by MM is based on the idea that investors can create homemade leverage
- ¡When investors use leverage in their own portfolios to adjust the leverage choice made by the firm.
¡MM demonstrated that if investors would prefer an alternative capital structure to the one the firm has chosen, investors can borrow or lend on their own and achieve the same result.
What if …nThe companies were not selling for the same price?
nArbitrage profits could be earned. An opportunity to make riskless profits exists and arbitragers will exploit this.
arbitrage
¡Arbitrage involves buying an asset and simultaneously selling it for a higher price, usually in another market, so as to make a
risk-free profit.
if the value of the levered company exceeds the value of the unlevered company,
an investor in the levered company should sell her shares and instead borrow money and invest in the shares of the unlevered company
if the value of the levered company exceeds the value of the unlevered company,
what will eventually happen?
If enough investors undertake similar transactions, there will be downward pressure on the price of L shares (because there are many sellers) and upward pressure on the price of U shares (because there are many buyers). Equilibrium will be restored when security prices have adjusted to the point where the market values of the two companies are equal.
If a levered company is overvalued, an investor in that company’s shares can
- replicate his risk and return by investing instead in the shares of an unlevered company and adjusting the debt–equity ratio by borrowing personally.
- Hence, leverage does not add value to a levered company because, by borrowing, the levered company is not doing anything that its shareholders cannot do for themselves.
if an unlevered company is overvalued, an investor in that company’s shares can
replicate his risk and return by investing instead in the shares of a levered company and adjusting his debt–equity ratio (to zero) by lending personally.
Leverage neither adds to, nor subtracts from, the value of a company.
what does arbitrage ensure
ensure that perfect substitutes will not sell at different prices in the same market at the same time.
describe substitutes in the context of MM’s analysis
In the context of the MM analysis, two companies with the same assets, but different capital structures, are perfect substitutes.
what happens when the market value of two companies are different?
If their market values are not the same, investors will enter the market to take advantage of the arbitrage opportunity and, in doing so, will force the values of the two companies to be the same.
nWe want to show that these two companies are equivalent, otherwise there must be an arbitrage opportunity.
Throughout the arbitrage process, the market will
will force returns to be the same, implying the degree of leverage does not have any impact on firm value and can be replicated by investors
since the difference between the values of the two companies could not persist, what would happen?
the actions of investors selling L’s securities and buying U’s shares would quickly establish an equilibrium in which their values would be exactly the same.
MM’s proposition 2
nThe cost of equity of a levered firm is equal to the cost of equity of an unlevered firm plus a financial risk premium, which depends on the degree of financial leverage:
draw the graph of MM’s second proposition
The firm’s overall cost of capital is unaffected by its capital structure.
MM Proposition 3:
n: The appropriate discount rate for a particular investment proposal is independent of how the proposal is to be financed
i. e. Whether the investing company obtains the funds by borrowing, or by issuing shares, or both, has no effect on the appropriate discount rate.
nlevel of risk associated with the project.
MM proposition 3
The key factor determining the discount rate or a proposal is the
nlevel of risk associated with the project.
Taken together, the MM propositions maintain that in a perfect capital market with no taxes,
it is only the investment decision that is important in the pursuit of wealth maximisation. The financing decision is of no consequence.
Therefore, investment decisions can be completely separated from financing decisions.
Capital Budgeting and the Weighted Average Cost of CapitalWith no debt, the WACC is
equal to the unlevered equity cost of capital.
Capital Budgeting and the Weighted Average Cost of Capital
what happens when the firm borrows at the low cost of capital for debt?
As the firm borrows at the low cost of capital for debt, its equity cost of capital rises. The net effect is that the firm’s WACC is unchanged
what does beta show?
The effect of leverage on the risk of a firm’s securities
what is unleveraged beta
A measure of the risk of a firm as if it did not have leverage, which is equivalent to the beta of the firm’s assets
If the company’s debt is assumed to be risk-free—
what is the beta?
Betad= 0
what is leveraged beta?
namplifies the market risk of a firm’s assets, βU, raising the market risk of its equity.
what is MM’s analysis also known as
the theory of irrelevance when there are no taxes
describe the second proposition of MM’s analysis
As shown in this diagram,
when you increase debt finance, the cost of equity increases as the financial risk of investors increase while cost of debt remains constant
describe the second proposition of MM’s analysis
what is the effect of the incrase in the cost of equity?
it offesets the adv of the low cost of the debt
which is WHY the overall cost of capital remains constant
what opportunity does arbitrate give investors
the ability to earn riskless profit
when may arbitrage be used?
when 2 firms are identical except for their capital strucutre have different market values of cost of capital
once again, what does MM theory say?
the capital structure is irrelevant to the cost of capital or market value of the firm and the price of the shares
If there are two firms identical in nature and have different market values, then this situation will not last long b/c arbitrage will take place until the market values are identical
according to MM approach, the cost of capital of a firm?
remains constant throughout the project’s life irrespective of the capital structure
when 2 firms are identical except for their capital strucutre have different market values of cost of capital
what will happen?
the different won’t last long on the market b/c arbitragers will notice the difference and exploit this arbitrage opportunity
describe the MM irrelevant proposition
the weighted average cost of capital (WACC) should remain constant with changes in the company’s capital structure.
For example, no matter how the firm borrows, there will be no tax benefit from interest payments and thus no changes or benefits to the WACC.
what does MM2 say?
It says that as the proportion of debt in the company’s capital structure increases, its return on equity to shareholders increase
MM 2 says that as the proportion of debt in the company’s capital structure increases, its return on equity to shareholders increase
why?
higher debt levels makes investing in the company more risky, so shareholders demand a higher risk premium on the company’s stock. However, because the company’s capital structure is irrelevant, changes in the debt-equity ratio do not affect WACC
nContrast with traditional perspective on capital structure with MM’s approach
- Low levels of leverage can reduce the weighted average cost of capital.
- Based on idea that equity holders do not perceive higher risks with low leverage levels.
MM’s analysis refutes this — average cost of capital cannot be reduced by issuing debt.
describe the classical tax system
- Applies to the US and foreign companies operating in Australia
- companies and shareholders are taxed independently
MM extended their original no-tax analysis to incorporate the effect of company income tax under the classical system
when is company taxed? what are the implications?
Company profit is taxed after allowing a deduction for interest on debt
This means that borrowing causes a significant reduction in company tax and a corresponding increase in the after-tax net cash flows to investors –> incentive to use debt
by incorporating taxes under the classical tax system, what happens?
Leverage will increase a firm’s value because interest
on debt is a tax deductible expense
by incorporating taxes in the MM analysis, what will happen to personal taxes
reduce the tax advantage associated with debt financing.
by incorporating taxes, show the cash flows of levered and unlevered companies
MM analysis (with tax)
first proposition says?
Value of a levered firm is equal to the value of an unlevered firm of the same risk class plus the present value of the tax saving
MM analysis (with tax)
what does this equation suggest?
levered company is always worth more than an equivalent unlevered company
the more it borrows, the greater is its debt, D, and the more its value increases. If the company tax rate is 30 per cent, then, company value increases by 30 cents for every dollar of debt in a company’s capital structure.
MM analysis (with tax)
what factor offsets the adv of debt financing as a way of reducing the company tax payable?
personal tax
draw proposition one with company tax
describe the 3 implications of miller’s analysis
- There is an optimal debt–equity ratio for the corporate sector as a whole but not individual company
- securities issued by different companies will appeal to different types of investors.
- ¡Shareholders of levered companies end up receiving no benefit from the company tax savings on debt
describe the 3 implications of miller’s analysis
first implication is that There is an optimal debt–equity ratio for the corporate sector as a whole but not individual company
why?
the optimal debt–equity ratio will depend on the company income tax rate and on the funds available to investors who are subject to different tax rates.
describe the 3 implications of miller’s analysis
2nd implication is that Securities issued by different companies will appeal to different clienteles of investors.
why?
For example, tax-exempt investors should invest only in debt securities, while investors subject to marginal personal income tax rates> company income tax rate should invest only in shares.
Therefore, companies with different capital structures will attract different investor clienteles
describe the 3 implications of miller’s analysis
3rd implication: The shareholders of levered companies end up receiving no benefit from the company tax savings on debt because the saving is passed on to lenders in the form of a higher interest rate on debt
- companies are effectively required to compensate the lenders for the additional personal tax payable on interest income –> lenders charge higher interest rate on borrowings
the classical tax system taxes
the classical system taxes company income in the hands of the company and then taxes it again when that income is passed on to the company’s shareholders as a dividend.
i.e. double taxation
To compare the effects of taxes on debt and equity under an imputation tax system, consider a dollar of EBIT and think of the company’s capital structure as determining whether this dollar is paid out as interest to lenders or used to provide a return to shareholders. The return to shareholders could be in the form of either
dividends or capital gains, depending on whether profit is distributed or retained by the company.
if Australian company tax has been paid, then most resident shareholders will benefit if
profits are distributed as franked dividends rather than retained.
imputation tax system
If the dollar of EBIT is used to pay interest to lenders, then company tax is
zero because interest paid is tax deductible for the company
Incorporating Taxes: Imputation Tax System
how does this work?
income distributed as franked dividends to resident shareholders is effectively taxed only once, at the shareholders’ personal tax rate
¡Interest paid to lenders is only taxed once at lender’s personal tax rate.
the imputation tax system is neutral between debt and equity.
Incorporating Taxes: Imputation Tax System
what does neutrality between equity and debt lead to?
we are back to MM’s Proposition 1 in the original no-tax case: the choice of capital structure does not affect a company’s value.
In showing that the imputation tax system can be neutral we have assumed that all profits are distributed as franked dividends.
Other results may be possible if profits are retained.
incorporating taxes: imputation tax system
what is the possible bias?
favours equity rather than debt as a source of company finance when personal income tax rates are greater than company tax
incorporation taxes: imputation system
does this system favour use of debt?
the Australian imputation tax system does not favour the use of debt finance by companies; it is either neutral or biased towards equity, depending on the investor’s marginal tax rate.
incorporation taxes: imputation system
this system is neutral or biased towards equity depending on the investor’s marginal interest rate
what can we conclude?
the same conclusion as Miller:
borrowing will not add value because the interest rate paid will reflect personal tax rates on interest that are equal to or higher than the overall tax rates on equity returns.
it is the structure of the system that makes it neutral or biased towards equity
incorporating taxes: imputation system
why may debt have tax advantages for Australian companies with a large overseas ownership?
overseas investors in Australian companies are outside the imputation tax system and are effectively still taxed under the classical system
what may financial distress do?
The costs of financial distress may also cause a company’s value to depend on its capital structure.
what is financial distress
A company is in financial distress when the company cannot meet its financial obligations or has difficulty meeting it
distinguish between serious and less serious cases of financial distress
serious cases –> may lead to the liquidation of the company
- Alternatively, put into receivership –> lenders appoint an administrator or receiver-manager —this may lead either to eventual liquidation or to control reverting to shareholders if the company trades out of its difficulties.
less serious –> company may meet all its commitments but the mere possibility of financial difficulties can change people’s behaviour.
- E.g. suppliers may demand cash on delivery
*
bankruptcy costs
Increasing a company’s debt–equity ratio increases (by borrowing)
how does this influene MM’s analysis and propositions?
increases financial risk for shareholders and also increases the risk that company will default on its debt (“debt is risky”)
- MM’s analysis shows that financial risk increases the cost of equity capital but has no effect on the weighted average cost of capital or on a company’s market value.
- MM’s Proposition 1 holds even if debt is risky: a company’s market value is not affected by its debt–equity ratio
When a company issues risky debt there is some probability that
the company will subsequently default, in which case direct bankruptcy costs will be incurred.
by issuing risky debt, a company gives outsiders
a potential claim against its assets, which must decrease the value of the company to its shareholders and/or its lenders.
nIncorporating the benefits and costs of debt, leads to the following expression of the value of a leveraged firm:
Value of a company
= value of an equivalent all-equity financed company
+ present value of the benefits of debt
– present value of expected bankruptcy costs
VL = VU + (PV of debt)
The PV of expected bankruptcy costs depends on the
nprobability of bankruptcy and PV of costs incurred if bankruptcy occurs.
the probability of bankruptcy increases when?
what trade off does this create?
the present value of expected bankruptcy costs will increase as a company’s debt–equity ratio increase ( the higher the leverage)
decision to borrow creates a trade-off between the advantage of tax savings and the disadvantage of expected bankruptcy costs.
in practice do bankruptcy costs exist?
examples of direct and indirect costs
how does this differ from MM’s proposition 1?
there are both direct costs of bankruptcy and indirect costs of financial distress, and these costs will affect companies that issue risky debt
- direct: mainly legal, accounting fees and fees to liquidators
- indirect: lost sales, fall in operating efficiency
this shows MM’s assumption that bankruptcy costs are zero (to arrive at the conclusion that market value of firm is unaffected if it holds risky debt) may not prove true in practice
indirect costs of financial distress relate to factors such as
the effects of lost sales, reduced operating efficiency and the cost of managerial time devoted to attempts to avert failure.
describe the indirect costs of financial distress and give an example
provides incentives for managers and other stakeholders such as customers, suppliers and employees to behave in ways that can disrupt a company’s operating activities and thus decrease its value.
e.g. managers are likely to pay less attention to issues such as product quality (customers respond by buying less –> reduced sales revenue) and employee safety –>
due to indirect costs of financial distress, what should a company do?
maintain an image of low-risk
can do this by lowering borrowings
what did titman (1984) suggest?
Sales, profits and share price would be greater if the company could assure customers and other stakeholders that it is very unlikely to liquidate.
Titman suggests that the choice of capital structure can, in effect, help to provide this assurance.
By borrowing less, a company decreases the probability of liquidation and hence improves the terms on which it trades with customers and other parties
n addition to its adverse effects on sales, a company’s risk of financial distress can also increase
give an example
In addition to its adverse effects on sales, a company’s risk of financial distress can also increase its operating costs and its financing costs.
e.g. a greater risk of financial distress will mean that it is harder to attract and retain skilled employees.
Similarly, it can impair a company’s ability to borrow and to obtain trade credit.
other market imperfections:
agency costs
how do agency costs arise
from the potential for conflicts of interest between the parties the company has contractual relationship with e.g. managers, employees, suppliers, shareholders, lenders
agency costs
conflicts of interest between lenders and shareholders
When a company borrows, the lenders may fear that ___
When a company borrows, the lenders may fear that managers will make decisions that will transfer wealth from them to shareholders.
list the potential areas of conflict between lenders and shareholders
¡Claim dilution
¡Dividend payout
¡Asset substitution
¡Under-investment
Conflicts of interest between lenders and shareholders
describe how dividend payout may cause their interests to conflict
If a company significantly increases its dividend payout, it decreases the company’s assets and therefore increases the riskiness of its debt –> transfers wealth from lenders to shareholders
Conflicts of interest between lenders and shareholders
describe how dividend payout may increase during financial distress
the incentives for managers to increase a company’s dividends become greater when the company is facing financial distress.
- the dividend payout provides a means for the shareholders to receive returns that otherwise are likely to go to the lenders on liquidation of the company.
Conflicts of interest between lenders and shareholders
describe asset substitution as a source of conflict
companies have an incentive to undertake high-risk investments, even when the market value is low and it may have -NPV (so when it is undertaken company will lose value) b/c
if it proves to be succesful, the benefits will be enjoyed be shareholders
If it fails, lenders will bear the costs
so value of shares increase and value of debt falls
conflicts of interest between shareholders and lenders
describe underinvestment as a source of conflict
A company may reject proposed low-risk investments that have a positive net present value.
conflicts of interest between lenders and shareholders
Lenders should realise that their wealth may be eroded by
what should they do?
managers’ decisions made in the best interests of the company’s shareholders.
lenders can protect themselves from such behaviour by increasing interest rates on debt (especially when the company borrows more)
conflicts of interest between lenders and shareholders
when lenders increase interest rate on borrowings to protect themselves, who bears the costs?
it is largely borne by the company’s shareholders
conflicts of interest between lenders and shareholders
another way for lender to protect themselves is by
examples include
requiring covenants (contracts) to be included in loan agreements
e.g. restrict additional debt from being issued, limiting dividend payments, company to maintain specific ratios, types of invesments the company can undertake
Covenants affect the value of the company and shareholders’ wealth
how
- monitoring is required to ensure the convenant is not infringed
- convenants may be too restrictive and prevent managers from pursuing value-maximising decisions e.g. undertaking high-risk, negative NPV projects
Conflicts of interest between shareholders and managers
how come?
shareholders have
managers
separation in ownership and control
little or no involvement in the company’s operations
managers conduct the day to day operations of the company
Conflicts of interest between shareholders and managers
what is a way to reduce it?
nby aligning the objectives of managers with those of shareholders:
Conflicts of interest between shareholders and managers
examples of ways to align shareholders and managers’ objectives
- employee share ownership schemes
- the inclusion of options on the company’s shares as part of the remuneration of top-level managers.
conflict of interests between shareholders and managers
Would it be best to eliminate the costs associated with the separation of ownership and control by having a company’s equity capital provided only by its managers?
discuss in terms of diversification
No
manager unlikely to reap full benefits of diversification (other shareholders diversify to reduce risk)
managers have skills and knowledge that are company specific (less valuable in other areas) –> require higher rate of return
conflict of interests between shareholders and managers
Would it be best to eliminate the costs associated with the separation of ownership and control by having a company’s equity capital provided only by its managers?
discuss in terms of free cash flow
what is free cash flow?
Jensen (1986) cash flow in excess of that required to fund all projects that have positive net present values.
e.g. if company is profitable but industry is declining so there are few positive NPV projects, there will be large free cash flows
conflict of interests between shareholders and managers
Would it be best to eliminate the costs associated with the separation of ownership and control by having a company’s equity capital provided only by its managers?
discuss in terms of free cash flow
Jensen (1986) Managers have considerable discretion in deciding how to use free cash flows and
Jensen argues that managers will be tempted to use free cash flows in ways that benefit them rather than the shareholders.
conflict of interests between shareholders and managers
Would it be best to eliminate the costs associated with the separation of ownership and control by having a company’s equity capital provided only by its managers?
give examples of how managers how managers may use free cash flow in their interest
invest in new projects or takeovers that increase their command in resources
conflict of interest between shareholders and managers
One way to reduce the agency costs of free cash flows is through
why?
dividend payments and share repurchases
Jensen argues that shareholders’ wealth should be increased if managers commit to paying out free cash flow as dividends or to buying back shares rather than retaining the cash within the company.
conflict of interest between shareholders and managers
how may debt be beneficial?
shareholders cannot force the manager to pay dividiends or repurchase shares
Debt may be beneficial when companies generate large free cash flows because it forces the payout of cash which reduces the potential for over-investment.
conflict of interest between shareholders and managers
there is a tendency for managers to overinvest
when make this be more likely
managers are more likely to overinvest when the company has higher free cash flows
Optimal Capital Structure: Trade-Off Theory
what are the pros and cons of debt
what does this lead to?
Pros: interest is tax-deductible
Cons: increased costs of financial distress
the trade off leads to an optimal capital structure. so an optimal capital structure exists and management should aim to maintain a debt-equity ratio
optimal capital structure: the static trade off theory
discuss what might happen when an all-equity company decides to issue a small amount of debt,
- expected costs of financial distress will increase slightly
- but the savings from interest which is tax-deductible outweighs the risk
so the firm’s value will increase
what does the static trade off theory propose?
there is an optimal capital structure (optimal debt-equity ratio) that maximises the value of a company
optimal capital structure: the static trade off theory
discuss what might happen when an all-equity company decides to issues more debt
- expected costs of financial distress increases as the risk of financial distress increases
- At some point, the higher costs will equal the higher tax savings.
optimal capital structure: static trade off theory
what point is the optimal debt-equity ratio
what happens if the debt-equity ratio is increased further?
Companies will borrow until the advantages of additional debt = disadvantages of additional debt.
Adv: tax deduction on interest
Cons: expected costs of financial distress that will arise if the company is unable to pay the interest that it owes.
If the debt–equity ratio is increased still further, the value of the company starts to decrease.
what is the static trade off theory
theory that proposes that companies have an optimal capital structure based on a trade-off between the benefits and costs of using debt
there is an optimal debt-equity ratio
draw a diagram to describe the optimal capital structure
Capital Structure with Information Asymmetry
what is the pecking order theory?
theory that proposes that companies follow a hierarchy of financing sources
- internal funds are preferred
- if external funds are needed, borrowing is preferred
- hybrid securities (converitible notes and preferences shares
- as a last resort, a new issue
of ordinary shares.
Capital Structure with Information Asymmetry
what can explain the pecking order theory?
Donaldson (1961) explains that it accords to the transaction costs of raising finance e.g. lowest transaction cost by using retained earnings
Myers (1984) it is based on information asymmetry
capital structure with information asymmetry
Information asymmetry and the undervaluation of a company’s assets
when is there information asymmetry?
when company managers have more information about their companies’ asset values and prospects than outside investors.
more accurate idea than the share market of the company’s ‘true value’; if it is greater or less than market value
capital structure with information asymmetry
Information asymmetry and the undervaluation of a company’s assets
provide an example
company issues 100,000 shares at market value of 4.50
short term (before sharemarket learns of the true value): information asymmetry between shareholders and managers; managers know that the true value of the shares is 5, greater than the market believes
- investment opportunity 200k outlay and 17k NPV, not known by outsiders and not reflected in share price (second information asymmetry)
Long term (after share market learns of the true value): more info available, share market will also value shares as 5
market informed of the investment –> share price rises
capital structure with information asymmetry?
what are the 4 alternative information and financing methods?
- investment announcement made before the share market learns the true value of the existing assets; new shares are issued
2. investment announcement made before the share market learns the true value of the existing assets; new shares are issued
- investment announcement made before the share market learns the true value of the existing assets; new debt is issued
4. investment announcement made before the share market learns the true value of the existing assets; new debt is issued
capital structure with information asymmetry
what is the best option?
investment announcement made before the share market learns the true value of the existing assets
the new investment project should be accepted immediately, and should be financed by debt.
capital structure with information asymmetry
what is the worst option?
investment is undertaken immediately and is financed by shares; investment announcement made before the share market learns the true value of the existing assets; new shares are issued
It is so bad that in the long term the shareholders lose as a result of undertaking an investment with a positive NPV.
implications of information asymmetry for financing policy
what does information symmetry cause
shares to be under or overvalued in the share market
implications of information asymmetry for financing policy
what will a manager do when a share price is overvalued and undervalued?
if a company’s managers believe that its shares are undervalued, they will prefer to borrow.
If they believe that the shares are overvalued, they will prefer to issue new shares.
why do new issues rank low in the pecking order?
b/c shareholders’ understand manager’s motives
if manager announces new share issue –> evidence that the company’s managers know bad news that is not yet known to outsidere i.e. the current share price is overvalued
so the share price will decrease when a new share issue is announced
capital structure with information asymmetry
what is the main implication for company managers?
since it is best for the company to accept a new project immediately and finance it by debt, they will need quick access to debt when there is a profitable investment opportunity –> reduce financial leverage
capital structure with information asymmetry
the company needs to have low leverage to access debt finance quickly
what if the company has high leverage?
high leverage, can only meet unexpected need for funds by issuing shares
shareholders believe managers are concealing something –> announcement causes company share price to fall (unless manager can convince shareholders they are not concealing adverse info)
capital structure with information asymmetry
the company needs to have low leverage to borrow at short notice instead of resorting to issuing shares immediately
how can the company ensure they have low leverage
by restricing debt to moderate levels
marketable securities that can be sold to provide cash and/or arranging lines of credit with unused borrowing limits.
main difference between pecking order theory and the static trade-off theory
pecking order theory does not rely on the concept of a target debt–equity ratio
Instead, a company’s observed capital structure will simply reflect the history of its capital requirements.
pecking order theory does not rely on the concept of a target debt–equity ratio
Instead, a company’s observed capital structure will simply reflect the history of its capital requirements.
give an example
a company enjoys exceptional profitability, which results in a substantial increase in its share price. Therefore, in market value terms, the company’s debt–equity ratio will have decreased.
main difference between pecking order and static trade off theory
if a company’s capital structure has not changed according to the static trade theory,
if a company’s optimal capital structure has not changed, then the company’s next capital raising should be debt, to move back towards the target debt–equity ratio.
main difference between pecking order and static trade off theory
what does the pecking order suggest if the company is profitable?
it may not need to raise external funds at all.
- profitable companies will tend to have low debt–equity ratios because of the availability of internal funds.
- Less profitable companies in the same industry will have higher debt–equity ratios because they generate fewer funds internally and because debt is first on the pecking order of external sources of funds.
Jensen’s Free Cash Flow Theory
Information asymmetry implies
that reserve borrowing capacity is valuable.
Jensen’s Free Cash Flow Theory
Reserve borrowing capacity is more valuable for
high growth companies. In more mature, stable companies it can cause free cash flows.
jensen’s free cash flow theory
what is slack for management
Where reserve borrowing capacity results in free cash flows, it offers slack for management.
information asymmetry
The problem of being forced to choose between forgoing a positive NPV project and seeing the share price fall because of a share issue can be overcome by
by maintaining ‘reserve borrowing capacity’ or ‘financial slack’ –> additional finance can always be raised at short notice to take advantage of profitable investments.
when there is information asymmetry between managers and investors, the announcement of a new share issue is likely to
cause share prices to fall
Therefore, if a company needs to issue new shares to finance a new project, the overall effect can be a reduction in shareholders’ wealth, even though the project has a positive net present value.
what are the implications of share price –> reduction in shareholders’ wealth after immediately announcing a share issue?
information asymmetry can effectively force companies to follow a financing pecking order in which internal funds are the first choice and external equity is the last choice.
what industries are likely to generate large free cash flows?
what are the implications
profitable companies in mature industries are likely to generate large free cash flows and managers may invest these cash flows in ways that benefit them rather than the shareholders.
BUT Jensen pointed out that debt can provide a solution to this overinvestment problem because it forces managers to pay out cash
While financial slack is valuable for some companies, it is not valuable for all companies.
why?
company that is very profitable but operates in an industry with few investment opportunities.
If this company has a low debt–equity ratio, it will have considerable financial slack. However, it will also have a large free cash flow, so there is a danger that its managers may squander resources on takeovers or diversification projects that benefit them but harm the shareholders.
jensen’s free cash flow theory
what does he suggeest about reserve borrowing capacity?
may not generate adequate returns and should be paid out to investors rather than retained in the company.
Jensen (1986) argues that free cash flows should be paid out to investors in order to avoid poor use of funds by managers.
Debt offers a ‘control effect’ generating a credible commitment not to misuse free cash flow, as it is required to service debt
Market Timing Theory by Baker & Wurgler (2002)
nFirms tend to issue equity instead of debt when:
¡market value (relative to book value and past market values) is high.
¡Cost of equity is relatively low
¡Investors are too enthusiastic about earnings prospects.
Market Timing Theory by Baker & Wurgler (2002)
nFirms tend to buyback shares when
¡market value (relative to book value and past market values) is low,
¡Cost of equity is relatively high.
Market Timing Theory by Baker & Wurgler (2002)
Graham & Harvey’s (2001) survey shows that
n2/3 of CFOs admit the importance of market timing in issuing equity.
Assessing Theories of Capital Structure: Trade-Off Theory
what does the trade-off theory propose?
It proposes that companies should borrow until the marginal tax advantage of additional debt is exactly offset by the increase in the present value of the expected costs of financial distress.
Assessing Theories of Capital Structure: Trade-Off Theory
what did myers argue?
Myers’ argument is that the static trade-off theory does not explain why companies are generally conservative in using debt finance
Assessing Theories of Capital Structure: Trade-Off Theory
give an example to explain myers argument
many large profitable companies such as Microsoft and the major pharmaceutical companies have operated for years with low debt ratios.
These companies have high credit ratings and could achieve significant interest tax savings by increasing their debt ratios without the probability of financial distress becoming more than remote.
limitations to the trade-off theory
- Cannot explain why companies are generally conservative in using debt finance.
2.Negative relationship between leverage and profitability
is not explained by trade-off theory.
- Cannot explain similar leverage levels across countries with different tax systems.
- Expect leverage to be higher in the US, where a classical tax system applies
how is the negative relationship between profitiabilty and leverage explained by the trade off theory according to myers?
High profitability means that the firm has more taxable income to shield, and that the firm can service more debt without risking financial distress
limitation to trade-off theory is that the trade-off theory does not explain similar leverage levels under different tax systems
expalin
If corporate borrowing has a significant tax advantage, as proposed by the static trade-off theory, then leverage should be higher in the US with its classical tax system than in other countries with imputation tax systems
assessing theories of capital structure: pecking order theory
what is the leverage like in high-growth, high-tech companies why?
leverage is typically low in high-technology industries where there are large growth opportunities and large needs for external finance
b/c they have mostly intangible assets and would therefore find debt very expensive. Further, heavy borrowing by such companies should expose them to the underinvestment problem.
describe the underinvestment problem
a company, or the shareholders of a company, choose not to invest in low-risk investments to maximise their wealth (they invest in high-risk, higher profit assets)
- low-risk investments would provide a safe cash flow to lenders
- The safe cash flow does not generate an excess return for the shareholders. As a result, the project is rejected, despite increasing the overall value of the company
- increases shareholders’ value at the expense of lenders
describe ther relationsihp between the manager and shareholder
and what the manager is supposed to do
The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximizeshareholder wealth.
However, it is in the manager’s own best interest to maximize his own wealth
what is the asset substitution problem
A problem that arises when a company exchanges its low-risk assets for high-risk investments.
This substitution transfers value from a firm’s bondholders to its shareholders.
explain the asset substitutin problem
- The transfer of assets places more risk on the debt holders without providing them with additional compensation.
- High-risk projects can yield higher profits, however more risk is incurred by the firm.
- The added profit may only benefit the shareholders, as the bondholders require only a fixed return.
- The increased risk affects the bondholders, since the company increases its chance of defaulting on its debt.
Assessing Theories of Capital Structure: Free Cash Flow Theory
- Reflects conflict of interest between managers and shareholders.
- potential to be misused by management (Jensen) Wants to prevent managers from investing in low-return projects.
- High leverage forces company to pay out cash and adds value by preventing unprofitable investment.
- Primarily applicable to companies with high free cash flows and poor investment opportunities — typically
‘mature cash-flow firms
The financing strategy should complement the investment strategy and take into consideration
¡Business risk.
¡Asset characteristics.
¡Tax position.
¡Maintenance of reserve borrowing capacity.
¡Other factors such as political and inflation risk.
describe MM’s irrelevance proposition
simplified version given their assumptions
the weighted average cost of capital (WACC) should remain constant with changes in the company’s capital structure.
- no matter how the firm borrows, there will be no tax benefit from interest payments and thus no changes or benefits to the WACC.
- since no changes or benefits from debt increases, the capital structure does not influence a company’s stock price, and the capital structure is therefore irrelevant to a company’s stock price.
describe MM II
The existence of higher debt levels makes investing in the company more risky, so shareholders demand a higher risk premium on the company’s stock.
However, because the company’s capital structure is irrelevant, changes in the debt-equity ratio do not affect WACC
MM II with corporate taxes state
MM II with corporate taxes acknowledges the corporate tax savings from the interest tax deduction –> changes in the debt-equity ratio do affect WACC.
Therefore, a greater proportion of debt lowers the company’s WACC.
MM’s analysis implied that in a perfect capital market, allcapital structure decisions are unimportant made under the assumptions.
When make capital structure decisions be relevant?
it may be relevant by taking into account the factors MM excluded by the assumptions
when may there be overinvestment?
conflict between mangers and shareholders’ interest where managers make investments for their own benefit
underinvestment can be severe for what kind of companies? why?
underinvestment problem can be severe for growth companies it should not be significant for mature companies with few profitable investment opportunities.
- The value mature companies comes mostly from assets in place that can be used as security for debt
underinvestment problem
why should growth companies restrict their leverage?
they lack tangible assets so
- debt is both difficult and expensive to obtain
- if it gets into financial difficulty, there are costs of invesments forgone
which is more difficult to add value to the company? financing or investment decisions? and why?
it is usually harder to add value by making good financing decisions than by making good investment decisions.
While a company may be able to find investment projects with positive NPVs, the highly competitive nature of financial markets means that it is much more difficult to make financing decisions that have positive net present values.
why are investment decisions important?
the primary source of a company’s value is the cash flows generated by its assets.
given the primacy of investment decisions, it seems sensible to suggest that
a company’s financing strategy should be designed to complement and support its investment strategy
while it is not easy to add value by making good financing decisions…..
while it is not easy to add value by making good financing decisions, it is certainly possible to reduce value by making poor financing decisions
describe an example of how poor financing decisions can reduce value
a high proportion of debt can reduce shareholders’ wealth because the expected bankruptcy costs become significant.
The probability of bankruptcy depends
partly on the company’s ability to meet its fixed financial commitments. By issuing debt, the company increases these financial commitments, and hence also increases its probability of bankruptcy.
what should a manager take into account when gauging the bankruptcy cost implications of issuing (more) debt?
the variability of future cash flows
The greater the variability of cash flows from its assets, the greater is the probability that, at some future time, the company will be unable to meet its financial commitments.
how may tangible and intangible assets determine how much can be borrowed?
tangible assets can be sold more easily
companies with a high proportion of tangible assets would be able to borrow more than companies that have a high proportion of intangible assets.
distinguish between general-purpose and company-specific assets
general-purpose assets: can be easily deployed for alternative purposes e.g. motor vehicle
company specific assets: worth much more in their current use than in any alternative uses e.g. highly specialised equipment
how can general-purpose and company-specific assets determine how much a company can borrow
General-purpose supports higher proportion of debt borrowing
company-specific less b/c company-specific assets it will lose much of their value if the borrower defaults and is liquidated SO expectedbankruptcy costs are high –> higher interest rate
how is company tax recovered under the imputation system?
company tax paid is effectively recovered by shareholders through receipt of franked dividends
how are non-residents taxed under the imputation system
non-residents cannot franking dividend; they are taxed under the classical system
why should a company’s financial strategy be designed to complement its investment strategy?
Because a company’s value depends primarily on the cash flows generated by its assets
what happens when perfect capital market assumptions are relaxed?
When the perfect capital market assumptions are relaxed, several factors could make capital structure important e.g. company income tax, personal income tax, the costs of financial distress, agency costs and information asymmetry.
distinguish how changing the capital structure under a classical/imputation system can influence the value of a company
classical system: increase in borrowings –> increase in interest –> interest is tax-deductible –> reduces company tax. This will add value if the company tax saved > personal income tax
imputation tax system: removes tax adv of debt
What are the potential advantages and disadvantages to a company’s shareholders if the company increases the proportion of debt in its capital structure?
Pro: may increase the returns to the company’s shareholders
Con: increases the risk of an investment in the company’s shares
MM analysis shows that any increase in shareholders’ wealth (when increase in wealth outweighs risk) can arise only from taxes or imperfections such as agency costs.
business risk
is the risk inherent in a company’s operations, and will depend largely on the industries in which the company operates.
financial risk
additional risk to which shareholders are exposed due to a company’s use of debt finance
Default risk
risk that a borrower may fail to make the repayments that are due to lenders.
Proposition 2: This is expressed as an equation as
Ke = K0 + (K0 - Ke) D/E
for a levered company, the cost of equity capital consists of:
(i) k0, which is the rate of return that investors require based on a company’s business risk;
(ii) an increment for financial risk which is proportional to the company’s debt–equity ratio and depends on the difference between k0 and kd.
Outline Miller’s argument that the tax advantages of debt are reduced or completely offset once personal taxes are included in the analysis. How appropriate is Miller’s analysis, given the Australian tax system?
most taxpayers do pay tax at a higher rate on income from debt than on income from shares. In addition, there are some investors who pay no tax on income from financial assets
Miller’s analysis was appropriate to Australia under the classical tax system, because the effective tax rate on income from debt was higher than that on income from shares, MM’s analysis does not apply in the imputation system
An investor will wish to invest in a company because of its capital structure. Discuss this statemet
if the personal tax on equity returns is zero, but interest on debt is taxed at the rate tp, then investors whose tp > tc (where tc = company income tax rate) would prefer to invest only in shares, while investors whose tp < tc would prefer to invest only in debt. This is one type of ‘clientele effect’
for investors with personal tax rates greater than the company tax rate, there can be an incentive to
retain, rather than distribute, profits.
Costs of financial distress will be borne entirely by lenders?
no
while realised liquidation costs are borne by debtholders (when equity becomes worthless), expected liquidation costs will be borne by shareholders (higher interest rate lenders charge to compensate)
t is obvious that companies should use as much debt as possible. It is cheaper than equity and the interest is tax deductible as well.
discuss
debt appears to be cheaper than equity—that is, kd < ke.
However, the interest cost of debt is only its explicit cost. Borrowing creates financial risk which causes the cost of equity capital to increase
. The fact that companies are allowed a tax deduction for interest would give debt an advantage if
income to investors in both debt and equity were taxed at the same rate. However, Miller points out that, generally, personal tax on debt is greater than that on equity.
He argued that this differential could exactly offset the tax deductibility of interest.
The probability of financial distress should be negligible for companies with a low proportion of debt. Therefore, a low proportion of debt should not have any noticeable effect on the cost of equity.
While the risk of financial distress may be negligible, any borrowing creates financial risk, and the MM analysis shows that shareholders will require compensation for that risk—that is, the cost of equity will increase as shown by their Proposition 2.
Outline the characteristics you would expect a company to have if it had:
a very low debt–equity ratio
likely to have a relatively low taxable income, a preponderance of illiquid assets such as intangible and/or company-specific assets, and operate in a high-risk industry.
Also, most companies in the early years of their operation are likely to use relatively small amounts of debt.
Outline the characteristics you would expect a company to have if it had:
a very high debt–equity ratio.
likely to have high and stable earnings, a preponderance of tangible, marketable assets, and operate in a low-risk industry
Would you necessarily expect companies in the same industry to have similar debt–equity ratios? Give reasons for your answer.
they have similar business risk.
However, companies in the same industry (for example, retailing) also operate with very different debt–equity ratios, which suggests that factors other than business risk are important in determining a company’s debt–equity ratio.
For example, since cash inflows are often used to repay debt, a more profitable company is likely to have a lower debt–equity ratio than other less-profitable companies in the same industry.
Suppose that the government substantially reduced the company tax rate in a classical tax system.
What would the Modigliani and Miller (with company tax) approach suggest about the effect of this change on the capital structures of companies?
The substantial reduction in the company income tax rate would not change the underlying principle of the MM analysis (with company tax)—that is, the value of a company can be increased by increasing the amount of debt in its capital structure.
Suppose that the government substantially reduced the company tax rate in a classical tax system.
What would Miller’s model predict about the effect on:
the quantity of debt for the corporate sector as a whole
With the reduction in the company income tax rate, the tax savings per dollar of debt will be lower; therefore, under the classical tax system, the quantity of debt should decline.
