BEHAVIORAL CORPORATE FINANCE (Ch. 6: Capital Structure) Presented by: Trisna Eka Wijaya ( ) Presented by: Trisna Eka Wijaya ( ) Ch. 6 Capital Structure

6.1 Traditional Approach To Capital Structure: Modigliani-Miller tradeoff theory: Focuses on the trade off between debt tax shields and financial distress. ◦ Increased tax shields on the positive side; ◦ Increased personal taxes and expected costs of financial distress on the negative side. Myers-Majluf pecking order theory: Pecking order theory suggest that a firm does not have an optimal debt to equity ratio. Instead, the firm follows a pecking order. If it needs additional financing, the firms first uses internally generated equity (cash). Once it exhausts its cash, it resorts to debt financing. If it exhaust its debt capacity, then it moves to new equity as a last resort. Ch. 6 Capital Structure

6.2 How Do Managers Choose Capital Structure In Practice? In practice, behavioral considerations (market timing) combine with traditional considerations to drive the capital structure decisions made by executives. A good indication that capital structure decisions reflect both traditional considerations and market timing come from the Financial Executive International (FEI) survey (September 2003). Ch. 6 Capital Structure

New Equity: Market Timing and Earnings Dilution Financial executive explicitly state that market timing is an important consideration in their capital structure decisions. Empirical evidence suggests that firm tend to issue new equity when their market to book ratios are high (when that equity is most likely to be overvalued). In the traditional approach, expected earnings per share (EPS) is directly related to the debt to equity ratio. Therefore, an equity issue would lower the debt to equity ratio, thereby driving down expected EPS. And executives might interpret lower EPS as dilution. Ch. 6 Capital Structure

New Debt: Financial Flexibility The top factor that drive financial executive’s decisions about new debt is financial flexibility. Having enough internal funds available to pursue new projects when they come along. Ch. 6 Capital Structure

Convertible Debt Convertible debt exhibits at least two behavioral features that make it appear attractive to financial executives: 1.The interest rate on convertible debt tends to be less than the interest rate on fixed debt, so convertible debt appears to be a cheap form of debt financing; 2.Because convertible debt converts to equity only when the future stock price rises, it appears to be a cheap form of equity as well. Ch. 6 Capital Structure

Target Debt to Equity Ratio The FEI survey indicates that executives decisions about capital structure reflect traditional tradeoff considerations as well as market timing. Survey evidence indicates that executives assign tradeoff considerations a lower priority than other competing concerns. Ch. 6 Capital Structure

Factors in The Debt Decision: 50% indicate that “maintaining a target debt-to-equity ratio” is important. 57% indicate that “Credit rating (as assigned by rating agencies)” is important. 45% indicate that “Tax advantage of interest deductibility” is important. 5% indicate that “Personal tax cost our investors face when they receive interest income” is important. Ch. 6 Capital Structure

Some empirical studies conclude that executives do establish target debt-to-equity ratios and attempt to close half the gap between current ratios and target ratios in less than two years. These studies suggest that market timing is a minor consideration. However, other empirical studies conclude that market timing is a major consideration, so the issue is not settled. Ch. 6 Capital Structure

Although traditional theory predicts that firms with lower costs of debt will choose to hold more debt than firms with higher costs of debt, the evidence suggests that the opposite is true. Ch. 6 Capital Structure

Firms with low expected costs of financial distress use debt conservatively. Large liquid firms in non-cyclical industries use debt conservatively. During the early 1990s, the unexploited tax shield by U.S. firms was about the same as the overall tax shields. During the early 1980s, the unexploited tax shield was almost three times higher. Ch. 6 Capital Structure

Traditional Pecking Order When large firms engage in substantial investments, they tend to rely on debt financing. However, they do not appear to exhaust their cash reserves before undertaking debt. Therefore, managers do not behave in strict accordance with pecking order theory. Ch. 6 Capital Structure

6.3 Behavioral APV In the traditional approach, managers make financing and investment decisions by maximizing adjusted present value APV, the sum of NPV and the value of associated financing side effects. Traditional financing side effects include tax shields and the flotation costs associated with new issues. However, financing side effects can also include terms that reflect perceived market mispricing. In this respect, the behavioral APV framework can accommodate behavioral element as well as traditional elements. Ch. 6 Capital Structure

Perception of Overvalued equity: New issues The first CEO of Amgen quipped that managers should issue new equity whenever markets are receptive, whether or not they need to finance projects at the time. Ch. 6 Capital Structure

Perception of Undervalued equity: Repurchases Financial executives who perceive the equity of their firms to be underpriced can repurchase shares. 75% of firms make the decision about repurchase policy after having determined their investment plans. Many financial executives are willing to reduce repurchases in order to fund new projects. Moreover, only about 25% believe that there are negative consequences attached to a reduction in repurchase activity. Ch. 6 Capital Structure

Behavioral Pitfall: Auto Nation Between January 2002 and June 2003, AutoNation repurchased $836 million of its stock, 20% of its outstanding shares. The firm makes its decisions about repurchasing shares in conjunction with its operational goal of earning a 15% return on its investments. The repurchasing decision to exploit market mispricing is treated like an investment projects in respect to opportunity costs. Ch. 6 Capital Structure

Underreaction The average market response to the announcement of an open market repurchase is 3.5%. Notably, investors appear to underreact to repurchases, in that stock prices drift upwards when firms repurchase shares. ◦ Stocks of firms who repurchase shares and have high book-to-market equity earn 4-year abnormal returns of 45.3%. ◦ When averaged over all firms, average abnormal return after the initial announcement is 12.1%. Ch. 6 Capital Structure

6.4 Financial Flexibility and Project Hurdle Rates Undervalued equity: cash poor firms reject some positive NPV projects. Undervalued equity for cash limited firms: invest or repurchase? Two key variables determine the appropriate adjustment to project hurdle rate. 1. the firm’s financing constraints; 2. the impact of the firm’s repurchase activity on the price of its shares. Ch. 6 Capital Structure

6.5 Sensitivity of Investment to Cash Flow The tendency for investment policy to depend on how much cash a firm holds is known as the sensitivity of investment to cash flow. The evidence is strong that when firms receive more cash or take on less debt, they invest more. Ch. 6 Capital Structure

Issues About Adaptec’s Approach to Capital Structure 1. Adaptec made unwise investments when it was cash rich and its stock price was high. 2. Young (Adaptec CEO) would not have chosen to issue what he perceived to be undervalued equity. Instead, he would have chosen to issue convertible debt. 3. Young made no reference to a target debt to equity ratio. Instead, he approached capital structure with a pecking order in mind: cash, followed by convertible debt, followed by external equity as a last resort. However, the basis for the pecking order did not appear to be asymmetric information, but rather his perception that his firm was undervalued in the market. Ch. 6 Capital Structure

Behavioral Pitfall: Adaptec Factors determining Adaptec’s capital structure: ◦ Cash. ◦ Current stock price. ◦ Convertible debt. Ch. 6 Capital Structure

6.6 Excessive Optimism, Overconfidence and Cash Excessive optimism and overconfidence leads managers to overestimate future project cash flows and underestimate project risk. As a result, these managers overestimate project NPV. When their firms are fairly valued in the market, the same biases lead them to conclude that their firms are undervalued. Ch. 6 Capital Structure

Cash Rich Firm If their firms are cash rich, managers have no need for external financing. As a result, they can use their cash to fund projects that they perceive to feature positive (or zero) NPV, but which in reality feature negative NPV. Ch. 6 Capital Structure

Cash Poor firm Excessively optimistic, overconfident managers of cash poor firms face a dilemma. In computing APV, they overestimate both project NPV and the associated financing side effects. In particular, their reluctant to avoid dilution can dominate their desire to fund a positive NPV project. As a result, they reject positive NPV projects when they are cash poor and have limited debt capacity. Ch. 6 Capital Structure

Identifying Excessively Optimistic, Overconfident Executives 1. The press coverage; 2. The CEOs hold their executive stock options until they are close to expiration (long holder). Ch. 6 Capital Structure

Longholders The investment policies of firms with excessively optimistic, overconfident managers display excessive sensitivity to cash flows. The evidence indicates that firms with longholder CEOs are more likely to rely on internal cash to finance investment than other firms. Longholding figures prominently as one of the key determinants of investment activity, along with cash flow, size of board of directors, and a measure of growth opportunities. Ch. 6 Capital Structure

Excessively optimistic, overconfident CEOs make the mistake of holding their executive options too long, and end up losing money. Interestingly, a substantial number repeat the mistake. Notably, firms whose investment is especially sensitive to cash flow have CEOs who have repeated the mistake at least once, and have lost money on their options at least once as a result. Ch. 6 Capital Structure

Behavioral Pitfalls: Scott McNealy In August 1997 Scott McNealy exercised options to buy 300,000 shares at $4.19. He sold them on the same days for over $46, receiving a gain of about $12.6 million. A spokesperson for Sun said that McNealy exercised the options because they were about to expire after 10 years. 2001, 2002, 2003: similar stories. Ch. 6 Capital Structure

6.7 Conflict Between Short Term and Long Term Horizons Consider a firm whose book-to-market equity ratio is low, and whose stock price has increased rapidly. Such a firm might earn low returns long- term, not because it is relatively safe, but because its stock is overpriced and its price will revert towards intrinsic value. Therefore, managers who adopt projects for short-term gain effectively act as if they use low discount rates in their capital budgeting analysis. Ch. 6 Capital Structure

In theory, managers have to decide whose interests they serve, investors who hold the stock for a short period and sell, or investors who plan to hold the stock long-term. There is no easy prescription to offer. In general, managers need to balance the two competing interests. Ch. 6 Capital Structure

Debiasing Errors or biases: Managers of cash rich firms undertake negative NPV projects and hold too little debt, while managers of cash poor firms avoid issuing external equity and reject positive NPV projects. Executives can check two indicators for excessive optimism and overconfidence. 1. The financial press to ascertain whether they have been characterized as optimistic and confident. 2. Their own stock option exercise policy. Ch. 6 Capital Structure

The End Ch. 6 Capital Structure