1. Advanced Corporate Finance Lecture 08.1 and 09 Capital Structure and Bond Valuation (Continued) Fall, 2010

2. Underinvestment Problem Given risky debt in the capital structure there is a tendency to 1.Reject positive NPV projects 2.Incentive to pay high dividends 3.May simply be impossible to Finance new investment because of debt overhang.

3. Example of Underinvestment UHFX International (million) For simplicity assume all security’s required return is 10% –Risk Neutrality and the probability of each state occurring is 50% Good State Bad State –Total 110 44 –Debt 66 44 –Equity 44 0 B = 50 S = 20 V = 70

4. Example of Underinvestment New investment Option I = 60 Pays off: 77 in good state, 66 in bad state NPV = $? million Finance with junior debt or equity

5. 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 B = 60 JB = 60 S = 15 ( A LOSS in value of $ 5 million) V = 135, and NPV is positive but hurts stockholders

6. Risk Shifting The Risk shifting problem occurs when it is in the interest of the stockholders to take on a very risky investment even though it has a negative NPV Example: 77 Investment = 30 » -33

7. Risk Shifting Cash Flow Before Investment Good State Bad State MV –Total 110 44 –Debt 66 44 –Equity 44 0 CF from Investment 77 -33 Total Cash Flow 187 11 –Senior Debt 66 11 –Junior Debt 66 0 –Equity 55 0

8. Risk Shifting Cash Flow Before Investment Good State Bad State MV –Total 110 44 70 –Debt 66 44 50 –Equity 44 0 20 CF from Investment 77 -33 20 Total Cash Flow 187 11 90 –Senior Debt 66 11 35 –Junior Debt 66 0 30 –Equity 55 0 25

9. Values Before After Firm 70 90 Snr Debt 50 35 Jnr Debt -- 30 Equity 20 25

10. Costs of Financial Distress V = V(u) + PV of Tax Shield Firm Value Debt Level Static Tradeoff Optimal Debt Level

11. Pecking Order Hypothesis Costly Information –Managers know more about the future of the firm than do outsiders Conclusion –Firm has an ordering under which they will Finance First, use internal funds Next least risky security

12. Announcement Effect of Capital Raising Choices Common Stock -3.14% Straight Debt -0.26%* Internally Financed +1.00% * Means not statistically significant What is the rationale (theory)?

13. 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.

14. 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

15. Empirical Evidence Schwartz & Aronson: Leverage tends to decline as the proportion of total value of the firm consists of Growth Opportunities. Information costs: Very strong relationship between type of capital structure change and price change It is difficult to distinguish between tradeoff theory and Pecking Order Taxes: Leverage increases associated with high taxes

16. 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