Advanced Corporate Finance FINA 7330

1

• Advanced Corporate FinanceFINA 7330
• Capital Structure Issues and Financing
• Fall, 2006

2
The Theories of Capital Structure

• Irrelevance
• Static Tradeoff
• Pecking Order
• Organizational Theory

3
The Irrelevance Theorem

• Perfect Capital Market Setting
• No Taxes
• No Contracting Costs
• Costs of Financial Distress
• Agency Costs
• No Information Costs

4
Irrelevance Theorem

• LIABILITIES
• DEBT 0
• EQUITY 3,000,000
• TOTAL 3,000,000

• ASSETS
• PVA 1,000,000
• PVGO 2,000,000
• TOTAL 3,000,000

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Irrelevance Theorem

• ASSETS
• PVA 1,000,000
• PVGO 2,000,000
• TOTAL 3,000,000

• LIABILITIES
• DEBT 1,600,000
• EQUITY 1,400,000
• TOTAL 3,000,000

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Tax Implications
LIABILITIES DEBT 0
EQUITY 2,100,000 TOTAL 2,100,000

• ASSETS
• PVA 1,000,000
• PVGO 2,000,000
• - PV of Tax Liability 900,000
• TOTAL 2,100,000

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Tax Implications
LIABILITIES DEBT 1,600,000 EQUIT
Y 920,000 TOTAL 2,520,000

• ASSETS
• PVA 1,000,000
• PVGO 2,000,000
• Less
• PV of Tax Liability 480,0000
• TOTAL 2,520,000

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Stockholders Wealth

• Originally 2,100,000 in Equity Interest
• Now 920,000 in Equity Interest
  
• 1,600,000 in Cash
• 2,520,000
• Total Stockholders Wealth
  

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The Static Tradeoff Theory

• Benefits versus Costs of Leverage.
• Benefits Costs
• Taxes Financial Distress
• Resolution of Agency Costs
• Agency Costs Bondholder/Stockholder
• Manager/Stockholder
• Bankruptcy Costs
• Direct and
• Indirect
• Information
  Costs

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The Impact of Taxes on the Capital Structure
Decisions

• Firm Value S Free Cash Flow (t)
• (1k)t
• Market Value of the Firms Liabilities
  Plus Equity Value

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With Taxes

• Firm Value for an equity financed firm
• SFree Cash Flow (t) - Tax on operations
• (1r)t
• Market Value of the Firm
• Market Value of
  Equity
• V(u)

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With Taxes

• V V(u) Plus Present Value of Tax Shield on
  Debt.
• V V(u) (Corp. Tax Rate) Debt
• In the special case when debt is thought of as
  perpetual.

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Graphically

• Firm Value (V)

V V(u) TcD
V(u)
Debt
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Cost of Capital
Ke r (r-Kd)D/E
WACC k
r
Kd
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Cost of Capital (After Tax)
Ke r (r-Kd)(1-T)D/E
r
WACC k r(1-T(D/V) )
Kd
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Static Tradeoff Theorem

• Costs of Financial Distress
• Potential Bankruptcy Costs
• Underinvestment
• Risk Shifting
• Agency Costs
• Assume
• Not Taxes
• Risk neutrality
• Single period
• Interest rate 10

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Bankruptcy Costs

• Widgets International
• Good State Bad State
• Pure Equity 11 million 2.2 million
• Probability of each state is 50
• Stockholders Wealth
• V 6 million
• E 6 million

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Bankruptcy Costs and Leverage

• Let the Firm issue a bond paying 4 million in
  principal, 0.4 million in interest.
• Widgets International
• Good State Bad State
• Total 11 million 2.2 million
• Debt 4.4 million 2.2 million
  
• Equity 6.6 million 0
• Stockholders Wealth
• V 6 million
• D 3 million
• E 3 million (Cash ) 3 million 6 million

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Direct Bankruptcy Costs

• Typically amounts to 2 to 5 of the distressed
  value of the firm
• Widgets International
• Again assume the same leverage of a bond
  promising to pay 4.4 million
• Good State Bad (Default)
• Total 11 million 2.2 million Bankruptcy
  cost 0.1 million
• Net 11 million 2.1 million

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Impact of Bankruptcy Costs

• Good State Bad (Default)
• Total 11 million 2.2 million Bankruptcy
  cost 0.1 million
• Net 11 million 2.1 million
• Value 5.95 million
• Debt 2.95 million
• Equity 3 million
• Thus stockholders wealth declines by 50,000
  (SHW 2.95 3 5.95 not 6)

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Underinvestment Problem

• Given risky debt in the capital structure there
  is a tendency to
• Reject positive NPV projects
• Incentive to pay high dividends
• May simply be impossible to Finance new
  investment because of debt overhang.

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Example of Underinvestment

• UHFX International (million)
• Good State Bad State
• Total 110 44
• Debt 66 44
• Equity 44 0
• D 50
• E 20
• V 70

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Example of Underinvestment

• New investment Option
• I 60
• Pays off 77 in good state, 66 in bad state
• NPV 5 million
• Finance with junior debt or equity

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If adopt, financed with Junior Debt

• UHFX International (million)
• Good State Bad State
• Total 187 110
• Debt 66
  66
• Junior Debt 88
  44
• Equity 33
  0
• D 60
• JD 60
• E 15 ( A LOSS in value of 5 million)
• V 135, and NPV is positive but hurts
  stockholders

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Risk Shifting

• Suppose the firm has value that will look like
  the following
• Value in Good State 4,500,000
• Value in Bad State 1,500,000
• With equal probability
• Promised payment to the Bondholder 3,500,000
• What is the value of the equity and the debt?

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Investment Opportunity

• Invest 1,000,000 to generate 1,500,000 with
  probability ½ in good state, 0 otherwise, so that
  New cash flows are
• 5,000,000 in good state
• 500,000 in bad state
• What is the NPV of the project, value of the debt
  and value of the equity?

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Distribution of Wealth
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• Example of Dividend Payment
• Example of Debt Overhang

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Firm Value
Costs of Financial Distress
V V(u) PV of Tax Shield
Debt Level
Optimal Debt Level
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Pecking Order Hypothesis

• Costly Information
• Conclusion
• Firm has an ordering under which they will
  Finance
• First, use internal funds
• Next least risky security

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Illustration

• Suppose there are two (similar) firms in the same
  industry. They both have assets in place which
  are fairly valued equally at 1,000,000. They
  both are financed with equity at this time. They
  both want to invest an additional 1,000,000 in
  an expansion project. The difference is that one
  firm expansion project has an NPV of 0 while the
  other has an NPV of 500,000. The problem
  however, is that investors dont know which firm
  is which and therefore each will be valued the
  same (say at 1,250,000.

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What will firms be worth?

• Assets Liabilities
• PVA 1,000,000 Equity 1,250,000
• PVGO 250,000
• Total 1,250,000 1,250,000

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Actually, Stockholders Wealth will depend on how
the Opportunity is Financed.

• Good Firm
• Debt Financed
• Equity 1,500,000
• Debt 1,000,000
• Total 2,500,000
• SH Wealth increased by 250,000

• Good Firm
• Equity Financed
• Old Equity (56)
• 1,400,000
• New Equity (44)
• 1,100,000
• Old SH Wealth increased by 150,000

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Actually, Stockholders Wealth will depend on how
the Opportunity is Financed.

• Bad Firm
• Debt Financed
• Equity 1,000,000
• Debt 1,000,000
• Total 2,000,000
• SH Wealth decreased by 250,000

• Bad Firm
• Equity Financed
• Old Equity (56)
• 1,120,000
• New Equity (44)
• 880,000
• Total 2,000,000
• Old SH Wealth decreased by 150,000

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So the announcement effect

• If the firm announces it intends to issue equity
  to invest in a project, this is bad news and
  stock prices will go down. That is the market
  will ASSUME this is a bad firm.
• Therefore the firm will never issue equity if it
  can avoid it to finance in projects.
• Thus pecking order.

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Empirical Evidence

• We tend to see that firms
• 1. Use internal funds to invest in projects if
  available
• 2. Use least risky securities as possible if it
  has to finance these projects externally.
• 3. Announcement of a new Debt issue has a small
  negative impact on stockprice
• 4. Announcement of a new Equity issue has a
  strong negative impact on stockprice

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Behavioral Theory

• Assumptions
• Manager's Objectives if to Maximize "Corporate
  Wealth" which consists of the sources of wealth
  and power under control of management.
• Thus, contrary to the classical finance
  assumption, managers are interested in maximizing
  some combination of stockholders wealth and their
  own power or benefits.

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Behavioral Theory

• How do we increase E S?
• Debt for equity swap Decreases Corporate Wealth
• But does so through increase in E and decrease in
  S!!!!
• What would increase S?
• FCF
• Managerial discretion

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What do we really mean by S?

• Excessive perks going to management
• Investing in safe projects rather than high NPV
  projects
• Concentrate on size rather than equity value
• Leverage would not be as large as is optimal

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How should we try to curb this?

• We want to motivate the managers to act in
  stockholders interest when there is a divergence
  between the two.
• Require constant and regular market tests
• Do not have much cash available for managers to
  waste
• Minimal retained earnings
• Large payments required to force management to
  produce
• Debt Payments
• Dividend commitment (implicit)
• The Market for corporate control Takeover
  Market
• Structure compensation packages and monitors to
  minimize this conflict of interest

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Bottom Line

• The capital structure (and dividend payout)
  decisions can be used to try to mitigate the
  impact of organizational theory.
• The idea here is to induce the firm to issue debt
  so that managers are faced with a constant stream
  of claims to satisfy and therefore cannot play
  with that cash.
• Also, minimize retained earnings and force the
  firm to be subject to market discipline on a
  regular basis.

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Generalizing

• When we look at established Capital Structures we
  tend to find evidence that supports a static
  tradeoff theory of capital structure
• When we consider changes in capital structure
  (issuing debt or equity, repurchases, calls,
  etc.) there tends to be a significant pecking
  order component