1. 13-1 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Chapter 13 Capital Structure Decisions

2. 13-2 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Learning Objectives Outline empirical evidence from recent studies on capital structure. Assess the implications of the evidence for the trade-off, pecking order and free cash flow theories. Explain how financing can be viewed as a marketing problem. Outline the main factors that financial managers should consider when determining a company’s financing strategy.

3. 13-3 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Introduction Modigliani and Miller (MM) analysis is useful in showing that if capital structure is important, the reasons must relate to factors that MM excluded by their assumptions. Four main theories of capital structure: –MM leverage irrelevance — company value depends on investment rather than financing decisions. –Trade-off theory — emphasises tax benefits of debt. –Pecking order theory — information on projects is asymmetric, and internal finance is highest in pecking order. –Free cash flow theory — emphasises agency costs with the discipline of debt reducing unprofitable investment.

4. 13-4 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Company Financing: Some Initial Facts In the US, most investment by non-financial companies is financed from internal cash flows, followed by external debt finance, and then by equity. The pattern in Australia is similar, with more than 50% of finance coming from internal equity between 2000–04. High-growth companies have investment needs that exceed cash flow and, as a result, these high-growth companies depend heavily on share issues (equity finance).

5. 13-5 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Company Financing: Some Initial Facts (cont.) Relationships between industry characteristics and capital structure have been reported in several studies. –Paper, steel and airline companies typically have high leverage. –Pharmaceutical and electronics companies typically have low leverage. –MacKay and Phillips (2005) study found that financial leverage is higher in concentrated industries than in competitive industries. These observations suggest that capital structure decisions are important.

6. 13-6 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Evidence on Capital Structure: Taxes Effects of personal and company tax tend to be offsetting: –Deductions for interest on debt reduce company tax. –However, at the investor level, interest is taxed more heavily than dividends and capital gains. However, managers may view non-debt tax shields, such as investment tax credits or tax losses being carried forward, as substitutes for interest deductions. Evidence of any significant relationship between leverage and taxes is sparse. MacKie–Mason (1990) argue that this is because most studies have tested for average rather than marginal effects.

7. 13-7 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Evidence on Capital Structure: Taxes (cont.) Examining individual financing decisions on a marginal basis for companies near the point of tax exhaustion, MacKie–Mason (1990) found strong evidence that taxes do influence financing decisions. Evidence for the US shows that high tax rate companies borrow more heavily than those with low tax rates. Evidence on imputation tax systems for Canada, New Zealand and Australia suggests that imputation removes the tax advantages of debt financing. Imputation reduces corporate financial leverage.

8. 13-8 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Evidence on Capital Structure: Financial Distress Trade-off theory — financial distress is the negative to be offset against tax benefits of debt. Direct costs of financial distress are small, but companies likely to fail incur indirect costs. Loss of sales occurs due to uncertainty, with company management focusing on aversion of failure rather than operations. Indirect costs of financial distress seem much larger than direct costs but are very difficult to measure.

9. 13-9 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Evidence on Capital Structure: Financial Distress (cont.) The costs associated with financial distress can reduce company value, but are they large enough to have an economically significant effect? Direct bankruptcy costs appear to be small. Indirect bankruptcy costs found to be significant. –Andrade and Kaplan (1998) — say that there is a need to separate economic and financial distress. –Based on their study of economically sound firms, Andrade and Kaplan found that net costs of financial distress are between 10–20% of firm value.

10. 13-10 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Evidence on Capital Structure: Agency Costs Debt and underinvestment: –High-growth companies with intangible assets will find debt expensive and difficult to obtain. –Companies that borrow and struggle to service debt will find it difficult to pursue other investments. –Debt will lead to underinvestment. Debt and overinvestment: –Mature companies with high free cash flows may pursue unprofitable investments. –Increased debt acts to discipline managers, curbing the inclination to overinvest: Jensen (1986).

11. 13-11 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Evidence on Capital Structure: Agency Costs (cont.) Leverage is generally negatively correlated with a company’s investment opportunities. Barclay, Smith and Watts (1995) (BSW), found evidence to confirm that a company’s investment opportunities are an important determinant of leverage. BSW’s results are opposite to those predicted by the pecking order theory.

12. 13-12 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Evidence on Capital Structure: Agency Costs (cont.) Maturity and priority of debt: –Previous discussion has implicitly assumed that all debt is the same. –However, debt can have many different features (maturity, security, priority, etc.). –Managers must not only decide how much debt to use but also what type of debt to use. Growth companies tend to use debt of shorter maturity and higher priority rather than mature companies.

13. 13-13 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Evidence on Capital Structure: Information Costs and Pecking Order Theory Pecking order theory: –Managers prefer internal finance. –Managers adapt target dividend payout ratios to their company’s investment opportunities (but dividends are ‘sticky’). –If internally generated cash flows are inadequate, the company draws first on its cash and marketable securities. –If external finance is required, the company issues debt first, then hybrids, and finally, equity.

14. 13-14 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Evidence on Capital Structure: Information Costs and Pecking Order Theory (cont.) The pecking order theory predicts that the announcement of a new share issue will cause the company’s share price to fall. –Pilotte (1992) found that the share price response to new financing, while negative, depends on the company’s investment opportunities and is not related only to the type of security being issued. –Price falls were larger for mature companies relative to growth companies. Pecking order theory implies that a company’s leverage depends on the difference between operating cash flows and investment needs over time.

15. 13-15 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Evidence on Capital Structure: Information Costs and Pecking Order Theory (cont.) Pecking order theory suggests that leverage is negatively related to profitability. Several studies over different time periods and in different countries confirm this prediction — –Jarrell and Kim (1984) –Titman and Wessels (1988) –Ranjan and Zingales (1995) –Wald (1999) –Graham (2000) –Graham and Harvey (2001)

16. 13-16 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Evidence on Capital Structure: Information Costs and Pecking Order Theory (cont.) Testing pecking order and trade-off theories: –Trade-off theory predicts a target adjustment behaviour of a company’s debt levels. –Pecking order theory predicts actual debt ratios will vary depending on need for external finance. –Shyam-Sunder and Myers (1999) compared the theories — and found that it is hard to distinguish statistically, but evidence supports pecking order theory.

17. 13-17 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Evidence on Capital Structure: Information Costs and Pecking Order Theory (cont.) –Fama and French (2002) — trade-off theory is unable to explain negative link between profitability and leverage. Small growth companies with low leverage depend on equity issues — which is inconsistent with the pecking order theory — and expect more dependence on debt. –Frank and Goyal (2003) — study shows that small firms in the US do not follow pecking order theory, and even larger firms’ support for the pecking order theory declines over time. –Evidence in support of pecking order theory is mixed — negative relationship between leverage and profitability is the strongest evidence. However, several explanations consistent with trade-off theory are proposed in the literature — and are open to empirical questioning.

18. 13-18 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Evidence on Capital Structure: Dual Issues and Spin-Offs Hovakimian, Hovakimian and Tehranian (2004) (HHT) study dual issues — companies that issue both debt and equity in same year expecting clean outcomes, i.e. debt ratio is more likely to be exactly what management want. No relationship between profitability and leverage after dual issue. Evidence supports hypothesis that firms have target capital structures.

19. 13-19 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Mehrotra, Mikkelson and Partch (2003) (MMP) study spin offs — new companies that are formed when separated from existing companies — again, leverage ratios of new companies can be chosen deliberately. MMP find that higher leverage is associated with higher profitability, lower variability of industry operating incomes, and greater proportion of tangible assets. No relationship between leverage and tax status. Apart from the absence of tax effect, MMP results are consistent with trade-off theory. Evidence on Capital Structure: Dual Issues and Spin-Offs (cont.)

20. 13-20 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Evidence on Capital Structure: Evidence from Surveys An alternative to empirical testing is to ask CFOs about what factors they consider when making capital structure decisions. Study by Brounen et. al. (2006) of 313 CFOs from UK, France, Germany and the Netherlands were consistent with the study by Graham and Harvey (2001) of 392 US CFOs. Consistent with trade-off theory is the fact that most CFOs reported having some kind of target debt–equity ratio. In both surveys, the desire for financial flexibility was the most important factor considered in debt decisions. Neither study found much evidence that CFOs considered assets substitution, asymmetry information, free cash flows, or personal tax as important factors.

21. 13-21 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Assessing Theories of Capital Structure: Trade-Off Theory Trade-off theory says firms should borrow until the marginal tax advantage of additional debt is offset by the marginal expected costs of financial distress. Trade-off theory explains some of the differences in capital structure of firms in different industries. Leverage is low when business risk is high and when assets are intangible (and unable to be used as security). Predicts leveraged buyout targets as mature companies with stable cash flows, tangible assets, and few growth opportunities.

22. 13-22 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Assessing Theories of Capital Structure: Trade-Off Theory (cont.) Limitations of trade-off theory: –Cannot explain why companies are generally conservative in using debt finance. –Cannot explain negative relationship between leverage and profitability. –Cannot explain similar leverage levels across countries with different tax systems. –Expects leverage to be higher in the US, where a classical tax system applies.

23. 13-23 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Assessing Theories of Capital Structure: Pecking Order Theory Pecking order theory explains the popularity of internal financing, and that when external finance is sought, it is usually debt. Also explains that less profitable firms need to borrow more. Low leverage in hi-tech industries? –Mostly intangible assets so borrowing is expensive. –Problem of debt induces underinvestment. Suggests that firms should raise external equity when all other sources are exhausted.

24. 13-24 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Assessing Theories of Capital Structure: Free Cash Flow Theory Reflects conflict of interest between managers and shareholders. Wants to prevent managers from investing in low- return projects. High leverage forces company to pay out cash and adds value by preventing unprofitable investment. Primarily applicable to companies with high free cash flows and poor investment opportunities — typically ‘mature cash-cow firms’.

25. 13-25 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Financing as a Marketing Tool Choosing a capital structure is essentially choosing a particular package of financial services to supply to investors. The instruments differ in: –Risk. –Return. –Taxation treatment. –Voting rights. –Priority in the event of liquidation. Differences also exist within categories.

26. 13-26 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Determining a Financing Strategy Evidence indicates that financing decisions are important and influenced by many factors. The financing strategy should complement the investment strategy and take into consideration: –Business risk. –Asset characteristics. –Tax position. –Maintenance of reserve borrowing capacity. –Other factors such as political and inflation risk.

27. 13-27 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Determining a Financing Strategy (cont.) Business risk: –Variability of net cash flows from a company’s assets is typically taken as business risk. –The greater the company’s business risk, the less it can borrow without raising probability of bankruptcy. –Thus, capital structure decisions and the optimal capital structure will be affected by business risk.

28. 13-28 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Asset characteristics: –Distinction between tangible and intangible assets is important for ability to borrow. –Similarly, distinction between company specific assets and general purpose assets is also important in determining ability to borrow. –Issue is the value of these assets as security against debt. –Agency costs of debt are high for companies with high levels of intangible assets — high monitoring costs mean debt is expensive and, therefore, not used by firms with high levels of intangibles. Determining a Financing Strategy (cont.)

29. 13-29 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Tax position: –Tax savings associated with debt depend on tax system in place in a particular country. –Key point is that with an imputation system as we have in Australia, the tax benefits associated with debt as a form of finance are at least partly neutralised. –This neutrality does not apply to non-resident shareholders of Australian companies — as a consequence, various classes of shares are issued to minimise the wastage of franking credits. Determining a Financing Strategy (cont.)

30. 13-30 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Maintenance of reserve borrowing capacity: –Information asymmetry issues create problems when seeking external equity finance to fund new projects — associated bad signals. –As a consequence, firms like to maintain reserve borrowing capacity to easily fund investment opportunities. –Allen (2000) finds that 60% of Australian companies retain reserve borrowing capacity or ‘financial slack’. –While valuable, creates free cash flow problems and may destroy shareholder value — Jensen (1986). Determining a Financing Strategy (cont.)

31. 13-31 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Other factors: political and inflation risk –Multinational companies will structure international projects using little equity and high levels of debt raised in the host country — this minimises political risk. –Inflation has an impact on interest rates, so floating rate borrowers need to consider inflation when deciding on debt levels. –Important to understand that cash flows and sales revenues can increase in the case of inflation, neutralising the problem. Determining a Financing Strategy (cont.)

32. 13-32 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Summary MM’s results imply that capital structure is not important. Similarities within industries and differences between industries suggest capital structure does matter. Factors affecting capital structure include taxes, costs of financial distress, companies’ investment opportunities, and free cash flows. Trade-off, pecking order and free cash flow theories all have empirical support, suggesting no one theory is right or wrong.

33. 13-33 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Summary (cont.) Financing can be treated as a marketing problem. Firms need to offer investors instruments that satisfy their tastes for risk–return trade-offs, tax treatment and voting rights. Financing strategy should complement investment strategy. Evidence from surveys of CFOs gives some support to trade-off theory with both tax benefits and financial distress receiving attention of CFOs. Need to consider business risk, asset characteristics, tax position, political and inflation risk, and the need for reserve borrowing capacity.