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Capital Structure Theory

Capital Structure Theory. Pecking Order. The Pecking-Order Theory. Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient Rule 1: Use internal financing first Rule 2: Issue debt next, equity last According to the pecking-order theory :

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Capital Structure Theory

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  1. Capital Structure Theory Pecking Order

  2. The Pecking-Order Theory • Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient • Rule 1: Use internal financing first • Rule 2: Issue debt next, equity last • According to the pecking-order theory: • There is no target D/E ratio • Profitable firms use less debt (they use self-financing instead) • Companies like financial slack

  3. Pecking Order Theory • The pecking order theory suggests that there is an order of preference for the firm of capital sources when funding is needed. • The firm will seek to satisfy funding needs in the following order: • Internal funds • External funds • Debt • Equity

  4. Pecking Order Theory • There are three factors that the pecking order theory is based on and that must be considered by firms when raising capital. • Internal funds are cheapest to use (no issuance costs) and require no private information release. • Debt financing is cheaper than equity financing.

  5. Pecking Order Theory 3. Managers tend to know more about the future performance of the firm than lenders and investors. Because of this asymmetric information, investors may make inferences about the value of the firm based on the external source of capital the firm chooses to raise. • Equity financing inference – firm is currently overvalued • Debt financing inference – firm is correctly or undervalued

  6. Pecking Order Theory • The pecking order theory suggests that the firm will first use internal funds. More profitable companies will therefore have less use of external sources of capital and may have lower debt-equity ratios. • If internal funds are exhausted, then the firm will issue debt until it has reached its debt capacity . • Only at this point will firms issue new equity. • This theory also suggests that there is no target debt-equity mix for a firm.

  7. How Firms Establish Capital Structure? • Most corporations have low D/V Ratios • Changes in leverage affect firm Value • Stock price increases with increases in leverage and vice-versa; this is consistent with M&M with taxes • Another interpretation is that firms signal good news when they lever up • Capital structure varies across Industries • There is some evidence that firms behave as if they had a target D/E ratio

  8. Factors in Target D/E Ratio • Taxes • If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt • Types of assets • The costs of financial distress depend on the types of assets the firm has • Uncertainty of operating Income • Even without debt, firms with uncertain operating income have high probability of experiencing financial distress • Pecking order and financial slack • Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient

  9. Long-term debt ratios (D/V) forselected industries IndustryBookMarket Pharmaceuticals 27.4% 7.34% Computers 24.75% 7.46% Steel 32.88% 14.61% Aerospace 46.32% 23.25% Airlines 71.88% 32.86% Electr. Utilities 61.74% 47.71% Auto & Truck 81.52%65.51% Internet 18.57% 2.18% Educational services 12.97% 2.24% Source: Bloomberg, January 2005 (collected by AswathDamodaran (NYU))

  10. Summary and Conclusions • Costs of financial distress cause firms to restrain their issuance of debt • Direct costs • Lawyers’ and accountants’ fees • Indirect Costs • Impaired ability to conduct business • Incentives to take on risky projects • Incentives to underinvest • Incentive to milk the property • Three techniques to reduce these costs are: • Protective covenants • Repurchase of debt prior to bankruptcy • Consolidation of debt

  11. Summary and Conclusions • Because costs of financial distress can be reduced but not eliminated, firms will not finance entirely withdebt Value of firm underMM with corporatetaxes and debt Value of firm (V) Present value of taxshield on debt VL = VU + TCB Maximumfirm value Present value offinancial distress costs V = Actual value of firm VU = Value of firm with no debt 0 Debt (B) B* Optimal amount of debt

  12. Agency Cost of Equity Agency Cost of Debt Summary and Conclusions • If distributions to equity holders are taxed at a lower effective personal tax rate than interest, the tax advantage to debt at the corporate level is partially offset. In fact, the corporate advantage to debt is eliminated if (1-TC) × (1-TS) = (1-TB) Value of firm underMM with corporatetaxes and debt Present value offinancial distress costs Value of firm (V) Present value of taxshield on debt VL = VU + TCB VL < VU + TCB when TS < TB but (1-TB) > (1-TC)×(1-TS) Maximumfirm value VU = Value of firm with no debt V = Actual value of firm 0 Debt (B) B* Optimal amount of debt

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