Advanced Corporate Finance FINA 7330 Capital Structure Issues and Financing Fall, 2006

The Theories of Capital Structure Irrelevance Static Tradeoff Pecking Order Organizational Theory

The Irrelevance Theorem Perfect Capital Market Setting No Taxes No Contracting Costs Costs of Financial Distress Agency Costs No Information Costs

Irrelevance Theorem ASSETS PVA$1,000,000 PVGO 2,000,000 TOTAL$3,000,000 LIABILITIES DEBT0 EQUITY3,000,000 TOTAL$3,000,000

Irrelevance Theorem ASSETS PVA$1,000,000 PVGO 2,000,000 TOTAL$3,000,000 LIABILITIES DEBT1,600,000 EQUITY1,400,000 TOTAL$3,000,000

Tax Implications ASSETS PVA $1,000,000 PVGO 2,000,000 - PV of Tax Liability 900,000 TOTAL $2,100,000 LIABILITIES DEBT 0 EQUITY2,100,000 TOTAL$2,100,000

Tax Implications ASSETS PVA $1,000,000 PVGO 2,000,000 Less: PV of Tax Liability 480,0000 TOTAL $2,520,000 LIABILITIES DEBT 1,600,000 EQUITY 920,000 TOTAL$2,520,000

Stockholders’ Wealth Originally: $2,100,000 in Equity Interest Now: 920,000 in Equity Interest $1,600,000 in Cash 2,520,000 Total Stockholders’ Wealth

The Static Tradeoff Theory Benefits versus Costs of Leverage. BenefitsCosts Taxes Financial Distress Resolution of Agency Costs Agency CostsBondholder/Stockholder Manager/Stockholder Bankruptcy Costs Direct and Indirect Information Costs

The Impact of Taxes on the Capital Structure Decisions Firm Value =  Free Cash Flow (t) (1+k) t = Market Value of the Firms Liabilities Plus Equity Value

With Taxes Firm Value for an equity financed firm   Free Cash Flow (t) - Tax on operations (1  t = Market Value of the Firm = Market Value of Equity = V(u)

With Taxes V = V(u) Plus Present Value of Tax Shield on Debt. V= V(u) + (Corp. Tax Rate) * Debt In the special case when debt is thought of as perpetual.

Graphically Firm Value (V) V = V(u) + Tc*D V(u) Debt

Cost of Capital WACC = k  Ke =  + (  -Kd)D/E Kd

Cost of Capital (After Tax) WACC = k =  (1-T(D/V) )  Ke =  + (  -Kd)(1-T)D/E Kd

Static Tradeoff Theorem Costs of Financial Distress –Potential Bankruptcy Costs –Underinvestment –Risk Shifting –Agency Costs Assume: Not Taxes Risk neutrality Single period Interest rate = 10%

Bankruptcy Costs Widgets International Good State Bad State Pure Equity 11 million 2.2 million Probability of each state is 50% Stockholders’ Wealth V = $6 million E = $6 million

Bankruptcy Costs and Leverage Let the Firm issue a bond paying $4 million in principal, 0.4 million in interest. Widgets International Good State Bad State –Total 11 million 2.2 million –Debt 4.4 million 2.2 million –Equity 6.6 million 0 –Stockholders’ Wealth –V = $6 million – D = $ 3 million –E = $3 million + (Cash =) 3 million = $6 million

Direct Bankruptcy Costs Typically amounts to 2% to 5% of the distressed value of the firm Widgets International –Again assume the same leverage of a bond promising to pay 4.4 million Good State Bad (Default) –Total 11 million 2.2 million Bankruptcy cost 0.1 million Net 11 million 2.1 million

Impact of Bankruptcy Costs Good State Bad (Default) –Total 11 million 2.2 million Bankruptcy cost 0.1 million Net 11 million 2.1 million Value 5.95 million Debt 2.95 million Equity 3 million stockholders’ wealthThus stockholders’ wealth declines by $50,000 (SHW = = 5.95 not 6)

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.

Example of Underinvestment UHFX International (million) Good State Bad State –Total –Debt –Equity 44 0 D = 50 E = 20 V = 70

Example of Underinvestment New investment Option I = 60 Pays off: 77 in good state, 66 in bad state NPV = $5 million Finance with junior debt or equity

If adopt, financed with Junior Debt UHFX International (million) Good State Bad State –Total –Debt –Junior Debt –Equity 33 0 D = 60 JD = 60 E = 15 ( A LOSS in value of $ 5 million) V = 135, and NPV is positive but hurts stockholders

Risk Shifting Suppose the firm has value that will look like the following: »Value in Good State = $4,500,000 »Value in Bad State = 1,500,000 »With equal probability »Promised payment to the Bondholder: $3,500,000 What is the value of the equity and the debt?

Investment Opportunity Invest $1,000,000 to generate: $1,500,000 with probability ½ in good state, 0 otherwise, so that New cash flows are: $5,000,000 in good state 500,000 in bad state: What is the NPV of the project, value of the debt and value of the equity?

Distribution of Wealth

Example of Dividend Payment Example of Debt Overhang

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

Pecking Order Hypothesis Costly Information Conclusion –Firm has an ordering under which they will Finance First, use internal funds Next least risky security

Illustration Suppose there are two (similar) firms in the same industry. They both have assets in place which are fairly valued equally at $1,000,000. They both are financed with equity at this time. They both want to invest an additional $1,000,000 in an expansion project. The difference is that one firm expansion project has an NPV of 0 while the other has an NPV of $500,000. The problem however, is that investors don’t know which firm is which and therefore each will be valued the same (say at $1,250,000.

What will firms be worth? Assets Liabilities PVA1,000,000 Equity 1,250,000 PVGO 250,000 Total 1,250,000 1,250,000

Actually, Stockholders’ Wealth will depend on how the Opportunity is Financed. Good Firm –Debt Financed Equity = 1,500,000 Debt = 1,000,000 Total = 2,500,000 SH Wealth increased by 250,000 Good Firm –Equity Financed Old Equity (56%) –1,400,000 New Equity (44%) 1,100,000 Old SH Wealth increased by 150,000

Actually, Stockholders’ Wealth will depend on how the Opportunity is Financed. Bad Firm –Debt Financed Equity = 1,000,000 Debt = 1,000,000 Total = 2,000,000 SH Wealth decreased by 250,000 Bad Firm –Equity Financed Old Equity (56%) –1,120,000 New Equity (44%) 880,000 Total = 2,000,000 Old SH Wealth decreased by 150,000

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.

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

Behavioral Theory Assumptions Manager's Objectives if to Maximize "Corporate Wealth" which consists of the sources of wealth and power under control of management. Thus, contrary to the classical finance assumption, managers are interested in maximizing some combination of stockholders wealth and their own power or benefits.

Behavioral Theory How do we increase E + S? –Debt for equity swap Decreases Corporate Wealth But does so through increase in E and decrease in S!!!! –What would increase S? FCF Managerial discretion

What do we really mean by S? Excessive perks going to management Investing in safe projects rather than high NPV projects Concentrate on size rather than equity value Leverage would not be as large as is optimal

How should we try to curb this? We want to motivate the managers to act in stockholders’ interest when there is a divergence between the two. Require constant and regular market tests –Do not have much cash available for managers to waste –Minimal retained earnings –Large payments required to force management to produce Debt Payments Dividend commitment (implicit) –The Market for corporate control: Takeover Market –Structure compensation packages and monitors to minimize this conflict of interest

Bottom Line The capital structure (and dividend payout) decisions can be used to try to mitigate the impact of organizational theory. The idea here is to induce the firm to issue debt so that managers are faced with a constant stream of claims to satisfy and therefore cannot “play” with that cash. Also, minimize retained earnings and force the firm to be subject to market discipline on a regular basis.

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