3Can Financing Decisions Create Value? Use NPV to evaluate financing decisions.How much debt and equity to sellWhen to sell debt and equityWhen (or if) to pay dividends“You can make a lot more money with smart investment decisions than with smart financing decisions.”Nonetheless, financing decisions are important:GOOD financing decisions won’t make you rich, but won’t put you out of business.BAD financing decisions can put you out of business.Quote from Brealey & Meyers
4Efficient Market Hypothesis (EMH) An efficient capital market is one in which stock prices fully reflect available information.The EMH has implications for investors and firms.Since information is reflected in security prices quickly, knowing information when it is released does an investor little good.Firms should expect to receive the fair value for securities that they sell. Firms cannot profit from fooling investors in an efficient market.Market efficiency is a funny thing:Markets are efficient precisely because there are lots of well-paid, well-financed, and smart security analysts who don’t believe that the markets are efficient…and their actions make the market efficient!
5Foundations of Market Efficiency Investor RationalityIndependence of eventsArbitrage
6The Different Types of Efficiency Weak FormSecurity prices reflect all historical information.Semistrong FormSecurity prices reflect all publicly available information.Strong FormSecurity prices reflect all information—public and private.
7Weak Form Market Efficiency Security prices reflect all information found in past prices and volume.If the weak form of market efficiency holds, then technical analysis is of no value.Since stock prices only respond to new information, which by definition arrives randomly, stock prices are said to follow a random walk.Stock prices following a random walk is not the same thing as stock prices having random returns.
8Semistrong Form Market Efficiency Security prices reflect all publicly available information.Publicly available information includes:Historical price and volume informationPublished accounting statementsInformation found in annual reports
9Strong Form Market Efficiency Security prices reflect all information—public and private.Strong form efficiency incorporates weak and semistrong form efficiency.Strong form efficiency says that anything pertinent to the stock and known to at least one investor is already incorporated into the security’s price.
10Information Sets All information relevant to a stock Information set of publicly available informationInformation set of past prices
11What the EMH Does and Does NOT Say Investors can throw darts to select stocks.This is almost, but not quite, true.An investor must still decide how risky a portfolio he wants based on risk aversion and expected return.Prices are random or uncaused.Prices reflect information.The price CHANGE is driven by new information, which by definition arrives randomly.Therefore, financial managers cannot “time” stock and bond sales.
12The EvidenceThe record on the EMH is extensive, and, in large measure, it is reassuring to advocates of the efficiency of markets.Studies fall into three broad categories:Are changes in stock prices random? Are there profitable “trading rules?”Event studies: does the market quickly and accurately respond to new information?The record of professionally managed investment firms.
13Are Changes in Stock Prices Random? Can we really tell?Many psychologists and statisticians believe that most people want to see patterns even when faced with pure randomness.People claiming to see patterns in stock price movements are probably seeing optical illusions.A matter of degreeEven if we can spot patterns, we need to have returns that beat our transactions costs.Random stock price changes support weak form efficiency.
14What Pattern Do You See?Click on the chart, and Excel will recalculate the series of random numbers automatically. You never know what you’ll see, but it’s kind of a fun game to make up projections of the stock price in the 26th period.
15Event StudiesEvent Studies are one type of test of the semistrong form of market efficiency.Recall, this form of the EMH implies that prices should reflect all publicly available information.To test this, event studies examine prices and returns over time—particularly around the arrival of new information.Test for evidence of underreaction, overreaction, early reaction, or delayed reaction around the event.
16Event Study ResultsOver the years, event study methodology has been applied to a large number of events including:Dividend increases and decreasesEarnings announcementsMergersCapital SpendingNew Issues of StockThe studies generally support the view that the market is semistrong form efficient.Studies suggest that markets may even have some foresight into the future, i.e., news tends to leak out in advance of public announcements.
17The Record of Mutual Funds If the market is semistrong form efficient, then no matter what publicly available information mutual fund managers rely on to pick stocks, their average returns should be the same as those of the average investor in the market as a whole.We can test efficiency by comparing the performance of professionally managed mutual funds with the performance of a market index.
18The Record of Mutual Funds Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and Seemingly Unrelated Assets,” Journal of Financial Exonomics, 63 (2002).
19The Strong Form of the EMH One group of studies of strong form market efficiency investigates insider trading.A number of studies support the view that insider trading is abnormally profitable.Thus, strong form efficiency does not seem to be substantiated by the evidence.
20Empirical Challenges Limits to Arbitrage Earnings Surprises Size “Markets can stay irrational longer than you can stay insolvent.” John Maynard KeynesEarnings SurprisesStock prices adjust slowly to earnings announcements.SizeSmall cap stocks seem to outperform large cap stocks.Value versus GrowthHigh book value-to-stock price stocks and/or high E/P stocks outperform growth stocks.
21Empirical Challenges Crashes Bubbles On October 19, 1987, the stock market dropped between 20 and 25 percent on a Monday following a weekend during which little surprising news was released.A drop of this magnitude for no apparent reason is inconsistent with market efficiency.BubblesConsider the tech stock bubble of the late 1990s.
22Implications for Corporate Finance Because information is reflected in security prices quickly, investors should only expect to obtain a normal rate of return.Awareness of information when it is released does an investor little good. The price adjusts before the investor has time to act on it.Firms should expect to receive the fair value for securities that they sell.Fair means that the price they receive for the securities they issue is the present value.Thus, valuable financing opportunities that arise from fooling investors are unavailable in efficient markets.
23Implications for Corporate Finance The EMH has three implications for corporate finance:The price of a company’s stock cannot be affected by a change in accounting.Financial managers cannot “time” issues of stocks and bonds using publicly available information.A firm can sell as many shares of stocks or bonds as it desires without depressing prices.There is conflicting empirical evidence on all three points.
24Capital Structure and the Pie The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity.V = B + SSBIf the goal of the firm’s management is to make the firm as valuable as possible, then the firm should pick the debt-equity ratio that makes the pie as big as possible.SSBBValue of the Firm
25Stockholder Interests There are two important questions:Why should the stockholders care about maximizing firm value? Perhaps they should be interested in strategies that maximize shareholder value.What is the ratio of debt-to-equity that maximizes the shareholder’s value?As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases.
26Financial Leverage, EPS, and ROE Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.)Proposed$20,000$8,000$12,0002/38%240$50CurrentAssets $20,000Debt $0Equity $20,000Debt/Equity ratio 0.00Interest rate n/aShares outstanding 400Share price $50The firm borrows $8,000 and buys back 160 shares at $50 per share.
27EPS and ROE Under Current Structure Recession Expected ExpansionEBIT $1,000 $2,000 $3,000Interest 0 0 0Net income $1,000 $2,000 $3,000EPS $2.50 $5.00 $7.50ROA 5% 10% 15%ROE 5% 10% 15%Current Shares Outstanding = 400 shares
28EPS and ROE Under Proposed Structure Recession Expected ExpansionEBIT $1,000 $2,000 $3,000InterestNet income $360 $1,360 $2,360EPS $1.50 $5.67 $9.83ROA 1.8% 6.8% 11.8%ROE 3.0% 11.3% 19.7%Proposed Shares Outstanding = 240 shares
29Assumptions of the Miller-Modigliani (MM) Model Homogeneous ExpectationsHomogeneous Business Risk ClassesPerpetual Cash FlowsPerfect Capital Markets:Perfect competitionFirms and investors can borrow/lend at the same rateEqual access to all relevant informationNo transaction costsNo taxes
30MM Proposition I (No Taxes) We can create a levered or unlevered position by adjusting the trading in our own account.This homemade leverage suggests that capital structure is irrelevant in determining the value of the firm:VL = VU
31MM Proposition II (No Taxes) Leverage increases the risk and return to stockholdersRs = R0 + (B / SL) (R0 - RB)RB is the interest rate (cost of debt)Rs is the return on (levered) equity (cost of equity)R0 is the return on unlevered equity (cost of capital)B is the value of debtSL is the value of levered equity
32MM Proposition II (No Taxes) The derivation is straightforward:
33MM Proposition II (No Taxes) Cost of capital: R (%)R0RBRBDebt-to-equity Ratio
34MM Propositions I & II (With Taxes) Proposition I (with Corporate Taxes)Firm value increases with leverageVL = VU + TC BProposition II (with Corporate Taxes)Some of the increase in equity risk and return is offset by the interest tax shieldRS = R0 + (B/S)×(1-TC)×(R0 - RB)RB is the interest rate (cost of debt)RS is the return on equity (cost of equity)R0 is the return on unlevered equity (cost of capital)B is the value of debtS is the value of levered equity
35MM Proposition II (With Taxes) Start with M&M Proposition I with taxes:SinceThe cash flows from each side of the balance sheet must equal:Divide both sides by SWhich quickly reduces to
36The Effect of Financial Leverage Cost of capital: R (%)R0RBDebt-to-equity ratio (B/S)
37Total Cash Flow to Investors All-equity firm Levered firmSGSGBThe levered firm pays less in taxes than does the all-equity firm.Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.This is how cutting the pie differently can make the pie “larger.”–the government takes a smaller slice of the pie!
38Summary: No TaxesIn a world of no taxes, the value of the firm is unaffected by capital structure.This is M&M Proposition I:VL = VUProposition I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage.In a world of no taxes, M&M Proposition II states that leverage increases the risk and return to stockholders.
39Summary: TaxesIn a world of taxes, but no bankruptcy costs, the value of the firm increases with leverage.This is M&M Proposition I:VL = VU + TC BProposition I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage.In a world of taxes, M&M Proposition II states that leverage increases the risk and return to stockholders.
40Costs of Financial Distress Direct CostsLegal and administrative costsIndirect CostsImpaired ability to conduct business (e.g., lost sales)Agency CostsSelfish Strategy 1: Incentive to take large risksSelfish Strategy 2: Incentive toward underinvestmentSelfish Strategy 3: Milking the property
41Example: Company in Distress Assets BV MV Liabilities BV MVCash $200 $200 LT bonds $300Fixed Asset $400 $0 Equity $300Total $600 $200 Total $600 $200What happens if the firm is liquidated today?$200$0The bondholders get $200; the shareholders get nothing.
42Selfish Strategy 1: Take Risks The Gamble Probability PayoffWin Big 10% $1,000Lose Big 90% $0Cost of investment is $200 (all the firm’s cash)Required return is 50%Expected CF from the Gamble = $1000 × $0 = $100NPV = –$200 +$100(1.50)NPV = –$133
43Selfish Strategy 1: Take Risks Expected CF from the GambleTo Bondholders = $300 × $0 = $30To Stockholders = ($1000 – $300) × $0 = $70PV of Bonds Without the Gamble = $200PV of Stocks Without the Gamble = $0$20 =$30(1.50)PV of Bonds With the Gamble:$47 =$70(1.50)PV of Stocks With the Gamble:
44Selfish Strategy 2: Underinvestment Consider a government-sponsored project that guarantees $350 in one period.Cost of investment is $300 (the firm only has $200 now), so the stockholders will have to supply an additional $100 to finance the project.Required return is 10%.NPV = –$300 +$350(1.10)NPV = $18.18Should we accept or reject?
45Selfish Strategy 2: Underinvestment Expected CF from the government sponsored project:To Bondholder = $300To Stockholder = ($350 – $300) = $50PV of Bonds Without the Project = $200PV of Stocks Without the Project = $0$ =$300(1.10)PV of Bonds With the Project:– $54.55 =$50(1.10)PV of Stocks With the Project:– $100
46Selfish Strategy 3: Milking the Property Liquidating dividendsSuppose our firm paid out a $200 dividend to the shareholders. This leaves the firm insolvent, with nothing for the bondholders, but plenty for the former shareholders.Such tactics often violate bond indentures.Increase perquisites to shareholders and/or management
47Can Costs of Debt Be Reduced? Protective CovenantsDebt Consolidation:If we minimize the number of parties, contracting costs fall.
48Tax Effects and Financial Distress There is a trade-off between the tax advantage of debt and the costs of financial distress.It is difficult to express this with a precise and rigorous formula.
49Tax Effects and Financial Distress Value of firm under MM with corporate taxes and debtValue of firm (V)Present value of tax shield on debtVL = VU + TCBMaximum firm valuePresent value of financial distress costsV = Actual value of firmVU = Value of firm with no debtDebt (B)B*Optimal amount of debt
50SignalingThe firm’s capital structure is optimized where the marginal subsidy to debt equals the marginal cost.Investors view debt as a signal of firm value.Firms with low anticipated profits will take on a low level of debt.Firms with high anticipated profits will take on a high level of debt.A manager that takes on more debt than is optimal in order to fool investors will pay the cost in the long run.
51The Agency Cost of Equity An individual will work harder for a firm if he is one of the owners than if he is one of the “hired help.”While managers may have motive to partake in perquisites, they also need opportunity. Free cash flow provides this opportunity.The free cash flow hypothesis says that an increase in dividends should benefit the stockholders by reducing the ability of managers to pursue wasteful activities.The free cash flow hypothesis also argues that an increase in debt will reduce the ability of managers to pursue wasteful activities more effectively than dividend increases.
52The Pecking-Order Theory Theory stating that firms prefer to issue debt rather than equity if internal financing is insufficient.Rule 1Use internal financing first.Rule 2Issue debt next, new equity last.The pecking-order theory is at odds with the tradeoff theory:There is no target D/E ratio.Profitable firms use less debt.Companies like financial slack.
53The Debt-Equity RatioGrowth implies significant equity financing, even in a world with low bankruptcy costs.Thus, high-growth firms will have lower debt ratios than low-growth firms.Growth is an essential feature of the real world. As a result, 100% debt financing is sub-optimal.
54How Firms Establish Capital Structure Most corporations have low Debt-Asset ratios.Changes in financial 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.There are differences in capital structure across industries.There is evidence that firms behave as if they had a target Debt-Equity ratio.
55Factors in Target D/E Ratio TaxesSince interest is tax deductible, highly profitable firms should use more debt (i.e., greater tax benefit).Types of AssetsThe costs of financial distress depend on the types of assets the firm has.Uncertainty of Operating IncomeEven without debt, firms with uncertain operating income have a high probability of experiencing financial distress.Pecking Order and Financial SlackTheory stating that firms prefer to issue debt rather than equity if internal financing is insufficient.