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Finance Lecture 3. Keating F&A 3-2 Spring 2008 Outline Lecture 3 A Target Capital Structure and What It Implies New Stock Issuances, Stock Repurchases.

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Presentation on theme: "Finance Lecture 3. Keating F&A 3-2 Spring 2008 Outline Lecture 3 A Target Capital Structure and What It Implies New Stock Issuances, Stock Repurchases."— Presentation transcript:

1 Finance Lecture 3

2 Keating F&A 3-2 Spring 2008 Outline Lecture 3 A Target Capital Structure and What It Implies New Stock Issuances, Stock Repurchases Principal-Agent Problems in Corporations

3 Keating F&A 3-3 Spring 2008 Last Lecture, We Talked About Options For Raising Money Retained earnings are easiest Debt is tax-advantaged, but it comes with bankruptcy risk New equity dilutes existing equity, may send a negative signal

4 Keating F&A 3-4 Spring 2008 Many Firms Have A “Target Capital Structure” A pre-determined ratio of debt to equity finance that management is to follow, e.g., 40% debt, 60% equity As earnings are retained (profits not paid out as dividends), equity investment grows  A moderate amount of new debt can be taken on in proportion to growth in retained earnings, preserving target capital structure

5 Keating F&A 3-5 Spring 2008 A Target Capital Structure Implies Higgins’ Sustainable Growth Rate Profits generate new retained earnings New retained earnings allow new borrowing in accord with target capital structure Sales can grow “sustainably” in parallel to the “natural” increase in equity and debt levels  “Sustainability,” in this context, means growth without need for new equity finance (beyond new retained earnings)

6 Keating F&A 3-6 Spring 2008 Suppose You Want A Sales Growth Rate Greater Than The “Sustainable” Rate You can cut the dividend rate, increasing retained earnings You can change the target capital structure to tilt more toward debt You can issue new equity (along with commensurate new debt)

7 Keating F&A 3-7 Spring 2008 Empirical Evidence On “Target Capital Structure” Is Less Overwhelming Than The Theory Is Elegant Most firms, in fact, use both equity and debt Firms with tangible assets, e.g., factories, do borrow more  Tangible assets can be put up as collateral, reducing borrowing costs Actual debt levels vary widely across apparently similar firms

8 Keating F&A 3-8 Spring 2008 Modigliani And Miller Wrote A Famous Nihilistic Paper On Capital Structure A firm’s value is unaffected by its capital structure  It doesn’t matter how a firm finances itself in equilibrium  “A pizza is still a pizza no matter how you slice it” Perturbations of MM tend to lead to corner solutions  The corporate income tax code favors debt financing so firms should take on as much debt as possible More on MM in Higgins’ Chapter 6

9 Keating F&A 3-9 Spring 2008 As A Practical Matter, Debt Past A Certain Level Is Impossible Real world bankruptcy costs discourage 100% debt financing  Legal costs of bankruptcy  Employees quit  Suppliers want cash up-front Most bonds have covenants limiting future bond issuances Bondholders don’t want to lend to a safe firm today that transforms into a risky firm

10 Keating F&A 3-10 Spring 2008 Outline Lecture 3 A Target Capital Structure and What It Implies New Stock Issuances, Stock Repurchases Principal-Agent Problems in Corporations

11 Keating F&A 3-11 Spring 2008 A Stock Issuance Starts With Some Preliminary Steps Existing stockholders’ preemptive rights must be honored  Existing stockholders have the first chance to buy any new shares issue  Prevents fraudulent dilution, e.g., management sells under-valued shares to cronies to maintain control Choice must be made between private placement and public offering

12 Keating F&A 3-12 Spring 2008 A Private Placement Directly Sells Stock To A Large Investor Can reduce flotation costs Can be done quietly But have you obtained a fair price?

13 Keating F&A 3-13 Spring 2008 If You Do A Public Offering, SEC Paperwork Is Considerable Registration Statement Prospectus Must report on insider trading activities Must follow proxy rules Goal is to make markets fair, open

14 Keating F&A 3-14 Spring 2008 You Probably Need An Investment Broker To Do Public Offering Are market conditions favorable? Best efforts assistance or underwriting? Investment banker owns then re-sells stock in underwriting (often leading a syndicate)

15 Keating F&A 3-15 Spring 2008 Even Without Underwriting Trading Profits, Investment Banking Costs Are Non-Trivial Source: Higgins, p. 171

16 Keating F&A 3-16 Spring 2008 One Wants Issuing Price To Be Fairly Close To Market Price Underwriter loses if issue is overpriced Firm forfeits possible funds if issue underpriced Investment bank doesn’t want reputation for gross underpricing (though it is tempting!)

17 Keating F&A 3-17 Spring 2008 Allegedly Chronic IPO Underpricing Is Controversial Underpricing, if it occurs, takes money away from the issuing firm Do investment bankers use underpriced IPOs to reward important insiders? Do issuing firms underprice as a form of advertising? Does underpricing help firm’s future issuances?

18 Keating F&A 3-18 Spring 2008 The Magnitude Of Stock Price Decrease From New Issuance Is Unclear New issuance thought to be a negative signal How profitably are you investing extra funds? How horizontal is demand curve for firm’s stock?

19 Keating F&A 3-19 Spring 2008 Some Firms Pay Dividends While Issuing New Stock Seems wasteful: New stock issuance is costly, dividend recipients pay income taxes Clientele effect: Existing stockholders may have come to count on dividends Stockholders may not trust managers so may welcome scrutiny accompanying new stock issuance

20 Keating F&A 3-20 Spring 2008 From A Tax Perspective, A Stock Repurchase May Be Preferred To Dividends Corporation buys up some existing shares Smaller pool of remaining stockholders to share future flows (Hopefully) Resultant stock price increase a capital gain, not ordinary income

21 Keating F&A 3-21 Spring 2008 Stock Repurchases Have Other Advantages Sale of stock is up to investor; receipt of taxable dividend is involuntary Allows use of short-term excess cash without commitment of dividend increase A mechanism for large scale reduction in equity share in capital structure, if so desired

22 Keating F&A 3-22 Spring 2008 The IRS Can Get Concerned About Repurchases, However Not supposed to take actions solely to reduce income taxation of stockholders Management needs a “business justification” Probably not a problem if done in moderation

23 Keating F&A 3-23 Spring 2008 In Contrast To Repurchases, Splits And Stock Dividends Are Fairly Meaningless Split of stock gives everyone more shares, but of lower value Stock dividend similar Want to keep price in “optimal” range? Perhaps a favorable signal Much ado about very little?

24 Keating F&A 3-24 Spring 2008 Outline Lecture 3 A Target Capital Structure and What It Implies New Stock Issuances, Stock Repurchases Principal-Agent Problems in Corporations

25 Keating F&A 3-25 Spring 2008 There Is A Motif Of Stockholders Not Trusting Managers One rationale presented, for instance, for new stock issuances concurrent with dividend payments is that stockholders welcome the scrutiny accompanying new stock issuances Another example is that stockholders may not want managers to have an open line of credit  Credit access allows quick action if opportunities arise  But will managers just buy private jets for themselves? → This is a Principal-Agent problem

26 Keating F&A 3-26 Spring 2008 Principal-Agent Problems Are Heavily Studied In Economics Principal: Stockholders Agent: Corporate management How do stockholders (the principal) make sure managers (the agent) behave in a way that maximizes stockholder wealth?  Effort is not directly observable  Observed outcomes include randomness and external factors not within managers’ control

27 Keating F&A 3-27 Spring 2008 It Is Widely Suspected Managers Want To Build Empires Compensation believed to be related to the size, not the profitability, of an enterprise The same theory has been presented for managers/bureaucrats in government agencies

28 Keating F&A 3-28 Spring 2008 One Incentive Correction Is To Tie Compensation To The Stock’s Price You want managers to “think like stockholders”  Risk averse managers probably don’t want too high a percentage of their wealth in the firm’s stock Call options provide especially strong incentives  A call option is only valuable if the stock price is above the option exercise price upon expiration of the option  Some executive have made gargantuan amounts from options  There are issues about how options are handled from a tax perspective

29 Keating F&A 3-29 Spring 2008 Takeover Threat Is A Major Check On Managers If a company is poorly run, an outsider could take on debt to buy out its stockholders and replace management  “Takeover artists,” “Corporate raiders”  Leveraged buyout While negatively depicted (by hardly disinterested managers), even the threat of takeover benefits stockholders by improving manager motivation “Poison pills” that discourage takeovers are not in shareholders’ best interests


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