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Capital Structure

Foundations of capital structure Originated with Modigliani and Miller (1958)Impact of capital structure on firm value (DCF)Increasing cash flowsDecrease WACCModel developed in three stagesWithout taxes and bankruptcy costsWith taxes but without bankruptcy costsWith taxes and bankruptcy co

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Capital Structure

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    1. M&M Theory (Static Trade-Off) Agency Theory Asymmetric Information (Pecking Order) Product/Market Interactions (Not discussed) Corporate Control (Not discussed) Capital Structure

    2. Foundations of capital structure Originated with Modigliani and Miller (1958) Impact of capital structure on firm value (DCF) Increasing cash flows Decrease WACC Model developed in three stages Without taxes and bankruptcy costs With taxes but without bankruptcy costs With taxes and bankruptcy costs M&M Theory

    3. Impact on Cash Flows Capital structure does not affect value of firm. Financing decision vs. Investment decision Impact on WACC WACC constant regardless of capital structure. If firm increases debt Risk to shareholders increases They demand higher returns Increased RE offsets D/E change and WACC unchanged. M&M Case I

    4. Impact on Cash Flows Tax gives rise to interest tax shield benefit. Tax shield benefit increases linearly with debt taken on. VL = VU + Tc x D Impact on WACC Cost of debt (RD) is interest payable on debt. RD reduced due to govt. subsidy on interest payments. Taking on debt therefore reduces WACC. Therefore optimal debt is 100%. M&M Case II

    5. Why is 100% debt not observed in practice? Debt increases risk of bankruptcy Bankruptcy destroys firm value As we take on debt we Increase firm value due to interest tax shield benefit But also increase cost of bankruptcy. Optimal capital structure Occurs where tax shield exactly offset by bankruptcy costs Beyond this point costs of debt outweigh benefits Essentially trade-off between tax benefits of debt and costs of bankruptcy (Static Trade-Off) M&M Case III

    6. Taxes: Tax benefit from leverage only important to firms in a tax-paying position (i.e. Profitable) Firms with substantial tax shields from other sources (e.g. Depreciation) receive less benefit. Not all firms have same tax rate. Higher tax rate, greater incentive to borrow. Important Conclusions

    7. Financial Distress: Firms with greater risk of financial distress will borrow less than those with less risk. Typically measure risk through volatility of PBIT. Financial distress also more costly to some firms than others depending on assets. Firms with mostly tangible assets can dispose of them more easily and cost-effectively than those with intangibles. Important Conclusions

    8. Critics contend M&M flawed once real world issues introduced. Perhaps our model needs to be extended? Previously only considered debt and equity for determining firm value. Various stakeholders have claim to cash flow of firms, however (e.g. government for taxes, potential bankruptcy costs, environmental groups, etc.) All of these can only be paid from cash flows of firm. M&M Theory Now

    9. Marketable versus Non-marketable Claims Marketable claims can be bought and sold in financial markets (e.g. Debt and equity) Non-marketable claims cannot (e.g. Taxes, bankruptcy costs) Firm value is thus sum of marketable and non-marketable claims Therefore cannot alter firm value by changing capital structure. Capital structure is important, however, because it determines split between marketable and non-marketable claims. Goal is to maximise marketable claims while minimising non-marketable claims. M&M Theory Now

    10. Managers versus Shareholders Agency problems arise between shareholders and management where manager equity stake in firm is low. More equity management holds, less agency conflicts likely. If we hold absolute equity stake of management constant, taking on debt increases their relative holdings in firm and reduces conflict between managers and shareholders. Debt can therefore be used to mitigate agency problems. Agency Theory

    11. Harris and Raviv (1990): Firms with higher liquidation values more likely to have debt and more likely to default as a result. Such firms will have higher market value than similar firms with low liquidation value and higher investigation costs. Stulz (1990): Optimal is trade-off between benefit of debt (preventing investment in value-decreasing projects) and costs of debt (preventing investment in value-creating projects) Firms with many good investment opportunities therefore likely to have less debt than those in mature, slow-growth industries. Managers versus Shareholders

    12. Debt contracts have limited upside Equity captures gains Debt may bear losses Over-investment by firms near bankruptcy Debt-holders bear the consequences High risks can be taken Even negative NPV projects may be attractive Selection of high risk projects Shifting risk erodes firm value (& debt value) Value is transferred from debt holders to equity holders Known as “asset substitution” Shareholders versus Debtholders

    13. Problems may be anticipated by lenders Higher interest charges Equity holders may counter by offering covenants Underinvestment by firms near bankruptcy (Myers, 1977) No incentive for equity holders to invest even in good projects Likely that benefit of gains will accrue to debtholders Larger debt levels may lead to rejection of value-adding projects Shareholders versus Debtholders

    14. Diamond (1989) Firms have incentive to pursue safe projects Debtholders dislike firms with history of risky investments Build history of safe investments for best lending terms May be incentive for small firms to take on risky investments early in life If they survive without defaulting, will eventually switch to safe projects Therefore likely that younger firms have less debt than older ones Shareholders versus Debtholders

    15. Hirshleifer and Thakor (1989) Management reputation may also hinge on safe investments Managers focused on success versus returns May select project that has highest probability of success even if it won’t provide highest return to equity holders Such firms lend themselves to favourable debt terms and likely to have higher amounts of debt Shareholders versus Debtholders

    16. Managers possess private information re firm’s opportunities Capital structure decisions therefore sends signal to market re private information (Ross, 1977) Can also be used to limit inefficiencies in investment decisions due to information asymmetries (Myers and Majluf, 1984) Assymetric Information

    17. An equity issue Good news (+ve NPV projects)? Bad news (shares overvalued)? Discount share price! A debt issue Share prices don't fall - convey more positive news Management feels they can service new debt Asymetric Information

    18. Ross (1977) Managers possess more information on firm than market Managers benefit if equity value increases Managers penalized if firm goes bankrupt Investors take high debt levels as sign of quality Low quality firms have higher marginal costs of debt and therefore issue less debt Signalling

    19. Ross (1977) Finds that firm value and D/E ratio positively related However, greater debt also increases bankruptcy costs Quality firm able to accommodate costs of debt, however. Managers can therefore use debt to signal firm quality and improve firm value Signalling

    20. Myers and Majluf (1984) If investors less well-informed than insiders about value of firm’s assets then equity may be mispriced in market Assume firm issuing equity to finance new project and severe underpricing occurs New shareholders effectively received discount on investment while price of existing shares drop Therefore receive greater net return than they should have at expense of existing shareholders Existing may have captured more return if debt used instead of equity Avoid this by issuing security not undervalued by market (e.g. Debt) Investment and Capital Structure

    21. Conclusion (Myers and Majluf, 1984): Possibility of mispricing dictates capital structure decisions Firms always issue less undervalued assets first Typical order is: Internal funding (retained earnings) Low-risk debt Equity Theory referred to as ‘pecking order’ Investment and Capital Structure

    22. Brennan and Kraus (1987) Dispute pecking order theory of Myers and Marjulf (1984) Conclude firms do not necessarily have preference for debt before equity Entirely possible that for some firms debt is more risky and cost of repayment is higher than underpricing cost of equity Some firms therefore prefer debt before equity Investment and Capital Structure

    23. Booth (2001): Factors influencing capital structure decisions similar across developing and developed markets regardless of significant differences in financial environments Find that firms with good profits tend to have less debt (pecking order) Also significant information asymmetries exist making external financing potentially expensive. Also support for impact of asset intangibility on debt levels. The Financial Environment

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